Avoidance Vs Evasion – one page summary

ACCT553 wk 1

Introduction

We begin the course by discussing an overview of federal income taxation, from the history of taxation to its current embodiment, policy reasons behind tax law (including why changes to tax law occur over time), and the actual sources of federal income tax law. We will also begin discussing the tax formula, a bit of tax research, tax evasion versus tax avoidance, penalties, and tax accounting issues. So let's begin.

The Sources of Tax Law

The common body of tax law (CBOTL) is an amalgamation of

(1) constitutional

(2) legislative

(3) administrative,

(4) judicial authorities.

Constitutional and Legislative (i.e., Statutory) Authority 

U.S. Constitution

1. U.S. Constitution Art. I, Sec. 8 authorizes Congress to levy taxes;

2. Legislative-Art. I, Sec. 7 requires tax bills to originate in the House of Representatives; and Art. I, Sec. 2 requires direct taxes to be apportioned according to population.

The 16th Amendment, enacted in 1913, gives Congress (through appropriations bills originating in the House of Representatives) the ability to levy taxes on income from whatever source it is derived from.

Internal Revenue Code-1939 – Title 26

In 1939, with the growing complexity of the tax law, the multitude of revenue acts was codified into Title 26 of the United States Code, known as the Internal Revenue Code of 1939.

The Internal Revenue code has been amended- in:

1954

1986 – Tax reform act

2018 – Tax Cut Act (Dec 22, 2018)

Legislative Process

The chart below is a summary of the legislative process. In addition to being able to contest taxes through the IRS administrative appeal process and the court system (judicial process), taxpayers may be able to seek relief through the legislative process. Taxpayers may contact their congressional representative and express their opinions on legislation. After all, the U.S. Constitution, Art. 1, Sec. 7, requires that all revenue legislation originate with the House of Representatives. Also, before proposed treasury regulations become final treasury decisions, taxpayers have an opportunity to comment by offering suggestions or objections on how the treasury regulations should be worded.

How Taxes Are Created

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Administrative (i.e., Treasury Department and IRS) Authority and Process

Section 7805(a) of the Internal Revenue Code authorizes the Treasury Department (part of the executive branch of government) to issue rules and regulations in order to interpret and enforce the tax code.

In addition to the judicial process and remedies, taxpayers also have a rich administrative appeal process that they can use in trying to settle disputes with the IRS. There are even provisions for taxpayers to claim refunds after taxes have been paid.

Treasury regulations

Treasury regulations have the authority of law when dealing with the Internal Revenue Service. Even in court, they have significant judicial weight. But courts are not bound to follow these administrative interpretations if the interpretations are in conflict with tax law.

Nevertheless, an important distinction must be made here. The regulations issued under Code § 7805(a)'s general provision are more in the nature of interpretive regulations.

In contrast, there are also regulations issued that are more legislative in nature. These regulations receive specific congressional authority in the statute itself.

This type of regulation sanctions the Secretary of the Treasury to implement the law with regulations.

The code will direct the Secretary of the Treasury to draft regulations. For example, IRC § 358(b) states that, "[U]nder regulations prescribed by the Secretary, the basis determined under (a)(1) shall be allocated among the properties permitted to be received" (IRC § 358[b)]. This particular code section refers to basis to distributees without recognition of gain or loss.

Although this is beyond our scope, it is a good example of the statute granting specific authority to the secretary to issue legislative-type regulations. Treasury regulations are first issued in proposed form and subject to public comment. The following are types of treasury regulations issued.

1. Final regulations (treasury decisions in the Federal Register—TDs): They represent binding authority.

2. Temporary regulations: They represent binding authority for up to 3 years, and under Treas. Reg. § 7805(e)(1), temporary regulations shall also be issued as proposed regulations.

3. Proposed regulations: They represent nonbinding, persuasive authority. They may eventually become final regulations.

Revenue rulings

Revenue rulings are the official pronouncements of the National Office of the IRS. Like regulations, they interpret the tax law. But they address narrower issues and are a persuasive authority, but not a binding authority.

Revenue procedures

Revenue procedures are issued in the same manner as revenue rulings, but they deal with the internal management practices and procedures of the IRS.

Letter rulings

Individual letter rulings, also referred to as private letter rulings (PLRs), are issued for a fee by the National Office of the IRS upon a taxpayer's request and describe how the IRS will treat a proposed transaction for tax purposes. They give an indication of how the IRS views a particular issue but are not authoritative, except for the specific taxpayer who requested the ruling.

PLRs are considered influential—if not dispositive—for a business or individual with regard to a specific contemplated transaction. It is also common for tax lawyers to rely on PLRs to structure transactions for their clients, based on how the IRS would determine the tax consequences of such transactions.

Technical advice memoranda (TAMs)

TAMs are issued by the National Office of the IRS to one of the four regional offices or 33 district offices in order to address questions by IRS personnel concerning tax treatment for completed transactions.

They are indicative of IRS interpretations of a particular issue, but they may not be relied upon by taxpayers in general. They generally originate from commonly asked questions of IRS field officers who run across a particular issue that needs technical or legal clarification.

Determination letters

At the request of taxpayers, determination letters are issued by the district director of the IRS, rather than by the IRS's National Office, in order to provide guidance in applying the tax law.

Notices

Notices are issued to provide guidance by the IRS before revenue rulings and treasury regulations are available.

Announcements (Ann.)

Announcements are less formal than revenue rulings, regulations, or even notices. They supply general information, corrections, lists, and the like.

Actions on decisions (AOD)

Actions on decisions indicate the IRS's position on trial court litigation, indicating why the IRS will appeal or not appeal an adverse decision or why it is acquiescing or not acquiescing in a trial court decision.

General counsel memoranda (GCM)

General counsel memoranda explain the rationales behind revenue rulings, private letter rulings, and TAMs.

Field service advice (FSA)

Field service advice is issued by the National Office at the request of IRS personnel to clarify substantial tax issues of first impression.

IRS publications

IRS publications and tax form instructions are not authoritative law, but they do provide excellent instructions and examples that explain the tax law as it relates to tax return preparation. For example, the instructions for form Schedule D are very informative concerning capital gains and losses.

Go to  http://www.irs.gov/ (Links to an external site.)  and conduct a search on Schedule D. For an example of a publication, try publication 544, Sale and Other Dispositions of Assets. If one is in need of practical guidance on a low budget, these types of publications and instructions provide terrific insights from the IRS's point of view. They can be found at  http://www.irs.gov/ (Links to an external site.) . The IRS might be hard pressed to explain why instructions on its forms, or explanations and examples in its publications, are wrong.

Judicial Authority

Trial courts

There are three choices for litigating a federal tax dispute.

1. U.S. Tax Court:  http://www.ustaxcourt.gov/ (Links to an external site.) . The tax court is a national court. Its judges are tax specialists. Decisions of the Tax Court are generally considered to be more authoritative than decisions of other trial courts. The tax court is the only court in which a taxpayer can actually bring his or her case without first paying the tax.  Federal district court: 

2. District courts have jurisdiction over questions that involve any point of federal law, including such diverse topics as labor relations, civil rights, and criminal offenses. The taxpayer must first pay the tax due in order to be heard in district court. Thus, although the courts occasionally hear tax cases, they do not specialize in tax matters. Only in a district court can the taxpayer request a jury trial, but only for issues of fact, not issues of law. See, for example, the United States District Court for Northern District of Illinois,  http://www.ilnd.uscourts.gov/ (Links to an external site.) .

3. U.S. Court of Federal Claims: The U.S. Court of Federal Claims has jurisdiction over any monetary claim brought against the U.S. government. Like the district courts, the U.S. Court of Federal Claims does not specialize in tax matters.

U.S. circuit court of appeals

Once a case has been decided in a trial court, the losing party has a right to appeal. Appeals from the district court or tax court are to one of 12 U.S. circuit courts of appeals.

Each circuit is in a separate geographical region. For example, the U.S. Court of Appeals for the Seventh Circuit exercises jurisdiction over disputes of taxpayers residing in Illinois, Wisconsin, and Indiana.

Appeals from the U.S. Court of Federal Claims are to a separate federal circuit court of appeals called the United States Court of Appeals for the Federal Circuit, located in Washington, D.C. Thus, there are a total of 13 circuit courts of appeals.

U.S. Supreme Court

Appeals from the 13 circuit courts are to the U.S. Supreme Court.

U.S. Court of International Trade

The U.S. Court of International Trade can also hear certain tax cases relating to tariffs.

Bankruptcy courts

Bankruptcy courts hear bankruptcy matters, which may include tax liability issues.

Tax Research

Secondary sources

In addition to the primary sources for the tax law as we discussed above, such as the Internal Revenue Code, treasury regulations, IRS pronouncements, and court cases, there are many secondary sources of law that may contain the primary sources and help explain the tax law. These explanations may be persuasive and, at times, even be quoted in court cases, or they may be used by tax practitioners in pre–fact planning (open facts) or after-tax compliance issues (closed facts).

Such sources include CCH's Standard Federal Tax Reporter, Research Institute of America's United States Tax Reporter (RIA), Research Institute of America's Federal Tax Coordinator, Merten's Law of Federal Income Taxation, and the Bureau of National Affairs' Tax Management Portfolios (BNA).

In addition, there are many treatises, books, law reviews, and tax periodicals that help explain the tax law that may be cited by courts or used by tax practitioners in pre–fact planning or after-tax compliance issues. There are also professional newsletters issued to help practitioners stay abreast of current developments.

Electronic tax research systems

Electronic tax research systems such as WestLaw, CCH, RIA, and Lexis/Nexis retrieve documents stored in databases and can even search for related documents using key words or phrases. Access the Internal Revenue Code here:  https://www.law.cornell.edu/uscode/text/26 (Links to an external site.) .   (Links to an external site.)

Research model

1. After determining the facts, identify tax issues needing research.

2. Research for primary and secondary tax law authority relevant to the tax issues identified.

3. Evaluate the weight of the various authorities.

4. Based on the research found, re-examine the facts and issues to see whether your research is on point (answering your issues for the facts involved) or whether it brings up additional issues requiring further fact gathering and tax law research.

5. Based on the law found and the facts in the case, do an analysis and draw a conclusion, and then communicate the conclusion to your client. 

Budget research techniques

One budget tax research technique is to browse the Internet for tax websites and tax articles related to a particular tax problem you may need to solve.

Beware that not all tax articles and websites are correct or well documented. It may be that you will get what you pay for. On the other hand, there are many fine articles by fine authors that are well documented, and there are many tax websites that are well put together.

As mentioned above, IRS publications and tax form instructions provide excellent instructions and examples that explain the tax law as it relates to tax-return preparation, even if it is not deemed authoritative to avoid the substantial understatement penalty.

Tax Avoidance Versus Tax Evasion

Tax avoidance versus tax evasion

Good businesspeople should arrange their economic affairs in the best possible way to legitimately reduce income taxes.

Tax Evasion-

On the other hand, if a taxpayer intentionally fails to report income, that taxpayer is illegally evading taxes.

Let's look at the different ways in which the IRS may determine whether a taxpayer is avoiding (i.e., minimizing his or her tax liability) or evading taxes (i.e., not paying taxes that are required to be paid under the tax code).

The IRS relies on determining what the taxpayer's mens rea is, and conduct that may be determined unlawful includes the following.

· Keeping two sets of books or records, especially in a cash-based service business, which could lead to concealment of income

· Consistently making false or erroneous bookkeeping entries

· Creating false documentation to support false bookkeeping or tax records

· Knowingly providing false information to a tax return preparer

· Not maintaining records (i.e., destroying records)

· Storing or receiving deposits or assets in a different name or business name 

· Falsely claiming an exemption from tax liability

· Systematic failure to file tax returns

There is a key distinction here in that understating taxable income does not necessarily mean that there is willful evasion, but rather that illustrating a pattern of such behavior of underreporting (or a failure to report) implies an intentionality that makes the culprit subject to the judgment of the law.

The type of person a taxpayer is will also influence whether or not the IRS determines to pursue charges of tax evasion. For example, a highly educated attorney or CPA is more likely to face greater scrutiny of his or her tax returns than a person with a low level of education.

This is because courts have held that the more education a taxpayer attains, the more knowledge that taxpayer will have in certain basic economic and tax reporting matters, so the more responsible that person is for his or her financial actions.

Business purpose or substance over form

In order for a transaction to be valid, it must have a valid business purpose other than just saving on taxes. The courts will look to the substance of a transaction to determine whether it has a valid business purpose.

Although the form of a transaction is important, if it has no economic substance, it will not pass judicial scrutiny.

If it has economic substance beyond the mere tax consequences, the form of the transaction will also have to comply with the tax law.

Tax Penalties

We discussed the concepts of tax avoidance and tax evasion above. So, what happens if a taxpayer underreports taxable income or takes credits or deductions that are invalid? The answer depends on whether the taxpayer erroneously—that is, mistakenly—underreported income or fraudulently underreported income.

Delinquency penalties

There are two types of delinquency penalties: (1) penalty for failure to file a return and (2) penalty for failure to pay the tax.

Negligence penalty

IRC § 6662(a) provides for a 20% penalty for underpayment of tax due to negligence or intentional disregard of rules or regulations.

Substantial understatement penalty

IRC § 6662(d) imposes a 20% penalty on substantial understatements of tax unless the taxpayer has substantial authority for the position taken on the income tax return.

Penalty for aiding understatement of tax liability

IRC § 6701 provides 6663(a), that any person who aids in the preparation or presentation of any tax document in connection with matters arising under the internal revenue laws with the knowledge that the document will result in the understatement of tax liability of another person is subject to a penalty of $1,000 ($10,000 for a corporation) for a taxable period.

Civil fraud penalty

IRC § 6663(a) imposes a 75% underpayment civil fraud penalty.

Criminal fraud penalty

IRC § 7201 provides that anyone who willfully attempts, in any manner, to evade or defeat any tax or payment, shall, in addition to other penalties, be guilty of a felony.

Tax Formula

The following are the basic mechanics for determining tax liabilities for individuals and corporations (including shareholders of such corporations).

The Basic Mechanics of Determining Federal Income Tax Liability

 

1. Step 1: Determine gross income.

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2. Step 2: Subtract deductions to reach adjusted gross income.

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3. Step 3: Subtract either the (i) standard deduction or (ii) itemized deductions (whichever is larger) to reach taxable income. –Caveat for married filing separately-

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4. Step 4: Apply the appropriate tax rates (graduated) to taxable income from Step 3 to arrive at tax liability.

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5. Step 5: Subtract credits and prepayments from tax liability to reach net tax due or refund.

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In addition to these basic mechanics for determining federal income tax liability, the basic tax formula to calculate the tax liability for individuals is as follows.

Gross Income

Less IRA, Med savings,	Deductions for adjusted gross income
Equals	Adjusted gross income
Less	Greater of itemized deductions of standard deduction
Equals	Taxable income
Times	Tax rate
Equals	Taxable liability
Less	Tax credits and prepayments
Equals	Tax due or refunds

As you can see, there is some overlap between the determination of federal income tax liability for corporations and for individuals. Later in this course, we will focus on the differences between these two types of taxpayers.

Tax Year

Tax year

A tax year is the year in which tax liabilities accrue; it can be the calendar year or the fiscal year on the basis of which the taxable income and resulting tax liabilities are computed.

The tax year may not exceed 12 calendar months, except in certain situations where a 52–53-week tax year is adopted. The term calendar year means a period of 12 months ending on December 31. A fiscal year is defined as a period of 12 months ending on the last day of any month other than December.

Election of a tax year

A new taxpayer may adopt any tax year without obtaining prior approval from the IRS in the first year.

Sole proprietors must use the same period for business tax-reporting purposes that they use for their personal books. It is desirable that the accounting period chosen be in agreement with the natural business year. Jan-Dec

Except for partnerships that qualify under the business-purpose exception, a partnership must use the same tax year as that of its partners who have an aggregate interest of greater than 50% in the partnership's profits and capital.

Newly organized corporations have the unrestricted right to select their annual accounting period.

S corporations are required to have either a tax year ending on December 31 or any other tax year for which a legitimate business purpose is established.

Estates may adopt any tax year without obtaining prior approval.

Trusts, other than charitable and tax-exempt trusts, must be on the calendar year. Under certain conditions, farmers are now permitted to use a 3-year income averaging for farm income. 

Change in tax year

If a taxpayer wishes to change the annual accounting period and adopt a new tax year, with certain exceptions, prior approval must be obtained from the IRS before using the new period for tax purposes.

The taxpayer files Form 1128. A change usually is approved if there is substantial business purpose according to IRC § 442.

Accounting Methods

Review various accounting methods.

Major Accounting Methods

Accrual Income Planning Method

Hybrid Methods

Change in Accounting Method 

Click on the links on the above to learn more about various accounting methods.

Business Inventories

If inventories are income-producing factors, then not only must inventory records be kept, but the taxpayer must also use the accrual method of accounting for purchases and sales.

According to IRC § 471, the two valuations of inventory requirements are (a) it complies with the best accounting practice in the particular trade or business, and (b) it clearly reflects income.

The main inventory costing methods for allocating the cost of goods available for sale are

(a) weighted average cost

(b) ; (b) first-in, first-out (FIFO);

(c) (c) last-in, first-out (LIFO);

(d) Specific identification.

(e) Form 970 filed with the tax return in the year of change will allow the taxpayer to change the inventory costing method to LIFO, but once made, the election is irrevocable;

(f) IRS permission is required to change again. Uniform capitalization rules apply to manufacturing and purchasing of inventory.

Long-Term Contracts

Taxpayers typically are required to use the percentage-of-completion method when it comes to accounting for long-term contracts.

That said, certain circumstances do permit the use of either the modified percentage-of-completion method or the completed-contract method.