Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Section 12.7
Tax Planning 12-19
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12-20 Chapter 12
Tax Administration and Tax Planning
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consequences are dependent on the taxpayer’s tax rate. The taxpayer’s tax rate may be
defined in several ways. For tax-plan ning purposes, the taxpayer needs to understa nd the
difference between the ‘‘average’’ tax rate and the ‘‘marginal’’ tax rate. The average tax
rate merely represents the average rate of tax applicable to the taxpayer’s income and is cal-
culated as the total tax paid divided by the total income of the taxpayer. The marginal tax
rate represents the rate at which tax is imposed on the ‘‘next’’ dollar of income.
EXAMPLE Becky, a single taxpayer, has income of $40,000 during the current
year on which she pays tax of $6,194. Her average tax rate is 15.49
percent ($6,194/$40,000). If Becky’s income increases to $50,000, her
tax liability will be $8,694. Thus, Becky’s marginal rate is 25 percent
[($8,694 $6,194)/($50,000 $40,000)]. N
When making tax-planning decisions, the taxpayer’s marginal tax rate is the most
important tax rate. For example, Jason has a 30 percent marginal tax rate and a 20 percent
average tax rate and is conside ring making a tax-deductible investment of $2,000. His
after-tax cost of the investment is calculate d using his marginal tax rate, not his average
tax rate. Jason’s after-tax cost of the investment would be $1,400, calculated as follows:
[$2,000 ($2,000 30 percent)]. On the other hand, if Jason is to receive any additional
income, he knows that he will pay tax at a rate of 30 percent on the next dollar of income.
Examples of Tax Planning
Tax planning can be accomplished in many ways. The following three examples illustrate
possible tax-planning opportunities.
EXAMPLE [Home Ownership] Tim and Joyce are planning to purchase a new
personal residence costing $150,000. They are considering making
a $15,000 down payment and taking out a $135,000 mortgage.
The monthly payment on the home mortgage (principal and interest)
will be $1,200. Assume that during the first several years each $1,200
payment includes $1,100 of deductible interest, while the remainder
represents a repayment of principal on the loan. Tim and Joyce’s com-
bined marginal tax rate for both state and federal income taxes is
38 percent. Since the home mortgage interest is deductible, their
monthly after-tax cost of the home mortgage payment is $782, calcu-
lated as $1,200 (38% $1,100). Often the after-tax cost of the
house payment will be about the same cost as a monthly rent pay-
ment. In addition, the taxpayer is building equity in a house. The
United States tax laws make home ownership one of the most impor-
tant tax-planning investments available to taxpayers. N
EXAMPLE [Pension Plans] Bob is a self-employed CPA with net income from his
business of approximately $60,000 annually. Bob desires to save
$7,500 per year. Bob deposits $7,500 each year in a mutual fund with
an average 10 percent (taxable) annual rate of return (an after-tax
rate of 7 percent because Bob has a 30 percent marginal tax rate).
After 20 years he will have deposited $150,000 into his savings
account and the account will have a balance, including the interest
earned, of approximately $307,466. If instead, Bob establishes a quali-
fied pension plan (such as a SEP) in which to deposit his savings, he
can reap significant tax benefits. He will be able to deduct the
Section 12.7
Tax Planning 12-21
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contributions to the SEP thereby reducing his annual taxable income
and tax liability. In addition, the earnings will be allowed to accumu-
late on a tax-deferred basis and will be taxable only upon withdrawal
from the plan. After a period of time, this compounding of tax-
deferred earnings along with the investment of the tax savings result-
ing from the deductibility of the $7,500 annual contribution to the
SEP will result in the accumulation of significantly more funds than
under t he savings account alternative.
To illustrate, assume Bob makes an annual contribution of $7,500
to a SEP, in which the earnings are taxed only upon withdrawal.
Assuming Bob earns the same 10 percent on his contributi ons to the
SEP, after 20 years the plan account will have a balance of approxi-
mately $429,562 ($122,096 more than under the savings account
option). The greater accumulation is due to the tax-free compounding
of the earnings. In addition, the contribution to the SEP is deductible,
whereas the deposit to the savings account must be made from after-
tax dollars. Thus, Bob’s cost of making the deposit to the savings
account is actually $10,715 [$7,500/(1 .30)], the amount he must
earn before taxes to make a $7,500 deposit, as compared to the
$7,500 cost of making the deductible contributi on. If this annual ‘‘tax
savings’’ of $3,215 ($10,715 $7,500) is allowed to accumulate in a
separate account for the same 20-year period, an additional $131,801
could be accumulated at an after-tax rate of 7 percent.
When the SEP account balance is withdrawn after 20 years,
assuming the same marginal tax rate applies, Bob will pay income
taxes on the withdrawal date of $128,869 ($429,562 30%). This
leaves Bob with $300,693 after paying tax on the withdrawal. Bob
will have a total of $432,494 ($300,693 þ $131,801) available, after-
tax, at the end of 20 years. Thus, Bob will have accumulated $125,028
($432,494 $307,466) more than if he put $7,500 of after-tax dollars
in a savings account. N
Plans that provide for deductible contributions and/or tax-free compounding are excel-
lent tax-planning devices, and should be used to the taxpayer’s benefit whenever possible.
Taxpayers should be aware, however, that m arginal tax rates may ch ange, and therefore,
the benefits to be gained from the deferral of tax may vary significantly.
EXAMPLE [Income Matching] During the current year, Ed ha s a $15,000 passive
loss from a limited partnership. The loss is not deductible this year,
unless Ed has passive income against which the passive loss can be
deducted. Tax planning for Ed would suggest that he make an invest-
ment t hat will produce passive income. For example, assume Ed pur-
chases, for cash, a rental house. If the rental house produces $16,000
per year in passive income, the $15,000 passive loss could be used to
offset the rental income which is considered passive income. In
essence, Ed can produce $15,000 in nontaxable rental income during
the year. Producing income of the appropriate nature in order to
take advantage of available deductions is another example of good
tax planning. N
12-22 Chapter 12
Tax Administration and Tax Planning
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Tax Traps
Tax planning can help taxpayers avoid ‘‘tax traps.’’ A tax trap is a provision of the tax law that
can result in the taxpayer’s loss of an otherwise available tax benefit arising from a transac-
tion. Presented below are examples of certain tax traps of which taxpayers should be aware.
EXAMPLE [The Ordinary & Necessary Test] Under the tax law, for trade or
business expenses or expenses for the production of income to be
deductible, they must be ordinary and necessary. Mrs. G is a widow
who owns 100 shares of AT&T stock inherited from her late husband.
During the current year, she spends $500 to travel to the AT&T annual
stockholders’ meeting. She votes her 100 shares against the current
management group. The $500 is not deductible under the ordinary
and necessary test. Small shareholders (such as Mrs. G) do not normally
incur expenses to attend out of town shareholder meetings. N
EXAMPLE [Business Purpose Test] Taxpayers who undertake transactions solely
for tax purposes will find that the tax benefit of the transaction may
be disallowed. This disallowance takes place under the ‘‘business pur-
pose test.’’ Assume a taxpayer undertak es a tax-free corporate reor-
ganization solely to save taxes. Since the taxpayer has no business
purpose for the reorganization, the reorganization probably will not
qualify as tax free. Good tax planning requires that taxpayers estab-
lish a business purpose for a transaction so that any tax benefits will
not be lost. N
EXAMPLE [Reasonableness Test] The tax law requires that deductions be reason-
able. H owns a small business. During the summer, he hires his 19-year-
old son to work for him and pays him $2,000 per week. He pays other
employees $400 per week for similar work. The reasonableness test
will likely result in the disallowance of a business deduction for the
excess amount of salary paid to H’s son, $1,600 ($2,000 $400). N
There are many other tax traps that the taxpayer should be aware of when making
decisions with possible tax consequences. For example, the hobby loss a nd at-risk
rules can result in the disallowance of otherwise deductible losses. Good tax planning
requires that taxpayers understand and avoid the tax traps that could cause undesired
tax results.
Self-Study Problem 12.7
During the current year, K’s taxable income is $89,000 and he pays income tax
of $18,636. K is single, has no dependents, and does not itemize his deduc-
tions. J, who files in exactly the same manner as K, has taxable income of
$90,000 and pays income tax of $18,916.
1. What is K’s average tax rate? ____________
2. What is J’s average tax rate? ____________
3. What is J’s marginal tax rate? ____________
Section 12.7
Tax Planning 12-23
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
KEY POINTS
Learning O bjectives Key Points
LO 12.1:
Identify the organizational
structure of the IRS.
The national office is the headquarters of the commissioner of internal revenue. The com-
missioner of internal revenue is appointed by the president of the United States with the
advice and consent of the Senate.
The IRS maintains ten service centers where the IRS computers process the information from
tax documents such as tax returns, payroll tax forms, Form 1099s, and withholding forms.
The IRS maintains a national computer center in Martinsburg, West Virginia, where informa-
tion from various service centers is matched with records from other service centers.
The IRS has the authority to examine a taxpayer’s books and records to determine the cor-
rect amount of tax due, and the IRS also has the right to summon taxpayers to appear
before the IRS and produce necessary accounting records.
LO 12.2:
Understand the IRS audit process.
A primary function of the IRS is to audit taxpayers’ tax returns.
The office audit is conducted in an IRS office and is typically used for individual taxpayers
with little or no business activities.
In a field audit, the IRS agent reviews a taxpayer’s books and records at the taxpayer’s
place of business or at the office of the taxpayer’s accountant.
The IRS uses a computerized statistical sampling technique called the Discriminant Function
(DIF) System to select tax returns for most audits.
Under the DIF system, the IRS uses mathematical formulas to assign a DIF score to each return,
which represents the potential for discovery of improper treatment of items on the tax return.
The IRS also selects returns for audit using information from other sources such as inform-
ants, other governmental agencies, news items, and associated tax returns.
If an audit results in a disagreement between the agent and the taxpayer, the appeals procedure
begins with the IRS inviting the taxpayer to an informal conference with an appellate agent.
LO 12.3:
Define the common penalties for
taxpayers and tax preparers and
be able to apply them to specific
situations.
Taxpayers are charged interest on underpayments of taxes, and, in some cases, the IRS
pays interest to taxpayers when they overpay their taxes.
The interest rate applicable to underpayments and overpayments of taxes is adjusted each
quarter and is equal to the federal short-term rate plus three percentage points.
The failure to file is subject to a penalty equal to 5 percent of the tax due with the return,
for every month or portion of a month the return is late (to a maximum of 25%).
The penalty for failure to pay is ½ of 1 percent of the amount of taxes due for every
month or portion of a month that the payment is late (to a maximum of 25%).
The accuracy-related penalty is 20 percent of the applicable underpayment due to (1) negligence
or disregard of rules or regulations, (2) a substantial understatement of income tax, or (3) a
substantial valuation overstatement, as well as certain other understatements of income tax.
When a taxpayer files a fraudulent tax return, there is a fraud penalty equal to 75 percent
of the amount of underpayment of taxes attributable to fraud.
The tax law contains many other penalties applicable to taxpayers: A civil penalty of $500
and a criminal penalty of $1,000 are imposed for filing false withholding information, and
there is a $500 penalty for filing a ‘‘frivolous’’ tax return (or document) as a tax protest.
LO 12.4:
Apply the general rule for the stat-
ute of limitations on tax returns
and the important exceptions to
the general rule.
In general, the statute of limitations for a tax return runs for 3 years from the date the tax
return was filed or the return due date, whichever is later.
If a fraudulent tax return is filed or no return is filed, there is no statute of limitations.
If a taxpayer omits an amount of gross income in excess of 25 percent of the gross income
shown on the return, then the statute of limitations is increased to 6 years.
The statute of limitations for the deduction of a bad debt or worthless security is 7 years
(all other items on the tax return would normally be considered closed after 3 years).
The statute of limitations may be extended by mutual consent of the IRS and the taxpayer.
12-24 Chapter 12
Tax Administration and Tax Planning
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 12.5:
Describe the rules that apply to
tax practitioners and the Taxpayer
Bill of Rights.
Tax practitioners include commercial preparers, enrolled agents, attorneys, and certified
public accountants (CPAs).
Under the tax law, any person who prepares a tax return, including non-income tax returns
(e.g., excise tax returns), for compensation is a ‘‘tax return preparer.’’
Tax return preparer penalties include 1) $50 for failing to sign a tax return or failing
to furnish the preparer’s identifying number, 2) $50 for each failure to keep a copy of
the prepared return or include the return on a list of taxpayers for whom returns have
been prepared, or 3) $50 for failing to provide a taxpayer with a copy of the tax return
prepared.
The IRS has the burden of proof in any court proceeding with respect to factual issues, pro-
vided the taxpayer 1) introduces credible evidence of the factual issue, 2) maintains records
and substantiates items, and 3) cooperates with reasonable IRS requests for meetings, inter-
views, witnesses, information, and documents.
The tax law extends the attorney-client privilege of confidentiality in tax matters to nonat-
torneys authorized to practice before the IRS (e.g., CPAs and enrolled agents).
The Taxpayer Bill of Rights (IRS Publication 1) requires the IRS to inform taxpayers of their
rights in dealing with the Service, and expands taxpayers’ rights and remedies when they
are involved in disputes with the IRS.
LO 12.6:
Understand the basic concepts of
tax planning.
Tax planning is the process of arranging one’s financial affairs to minimize one’s overall tax
liability.
When illegal methods are used to reduce tax liability, the process can no longer be consid-
ered tax planning, but instead becomes tax evasion.
For making tax-planning decisions, the taxpayer’s marginal tax rate is the most important
tax rate to consider.
Tax planning can help taxpayers avoid ‘‘tax traps’’ which are provisions of the tax law that
may result in the taxpayer’s loss of a tax benefit arising from a transaction.
Reinforce the tax information covered in this chapter by completing the online
interactive tutorials located at the Income Tax Fundamentals Web site:
www.cengagebrain.com.
QUESTIONS and PROBLEMS
GROUP 1:
MULTIPLE CHOICE QUESTIONS
.............................................. .............................................. .
LO 12.1
1. Which of the following is a responsibility of a local office of the IRS?
a. Advising the Treasury Department on legislation
b. Intelligence operations
c. Appellate procedures
d. Developing IRS rules and regulations
e. None of the above
Questions and Problems 12-25
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 12.2
2. Which of the following is the most common type of audit for an individual taxpayer
who conducts no significant business activities?
a. Office audit
b. Correspondence audit
c. Telephone audit
d. Field audit
e. Service center audit
LO 12.3
3. Which of the following is not a penalty that may be imposed by the IRS?
a. Failure-to-file penalty
b. Failure-to-pay penalty
c. Penalty for negligence
d. Fraud penalty
e. All of the above may be imposed by the IRS
LO 12.4
4. If a taxpayer’s 2010 individual income tax return was filed on February 1, 2011, the
statute of limitations would normally run out on:
a. April 15, 2014
b. February 1, 2012
c. February 1, 2013
d. February 1, 2014
e. None of the above
LO 12.4
5. Which of the following deductions has a 6-year statute of limitations?
a. Depreciation
b. Salaries
c. Travel and entertainment
d. A return in which the taxpayer omitted gross income in excess of 25 percent of the
gross income shown on the return
e. Worthless securities
LO 12.2
6. In which of the following ways are tax returns selected for most audits?
a. Through the Discriminant Function System
b. Through informants
c. Through news sources
d. Through information from other government agencies
LO 12.5
7. Which of the following tax preparers may not represent their clients in all IRS
proceedings?
a. An enrolled agent
b. A commercial tax return preparer
c. A certified public accountant
d. An attorney
e. All of the above
LO 12.5
8. What are the minimum qualifications according to the IRS for starting a business as a
tax return preparer?
a. A public accounting certificate or a law degree
b. A high school education
c. Completion of an IRS examination
d. Two years of experience as an assistant tax preparer
e. There are no minimum qualifications
12-26 Chapter 12
Tax Administration and Tax Planning
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 12.5
9. The IRS does not have to furnish the taxpayer with information concerni ng which of
the following items?
a. The way the taxpayer’s return was selected for audit
b. The procedures for appealing an IRS ruling
c. The refund claims process
d. The IRS collection process
e. All of the above must be provided to the taxpayer
LO 12.6
10. Glen’s taxable income is $50,000 and he pays income tax of $8,688. If his income were
$60,000, he would pay taxes of $11,188. What is Glen’s marginal tax rate?
a. 18.65%
b. 17.38%
c. 22.38%
d. 25.00%
e. Some other amount
LO 12.6
11. Melodie’s taxable income is $40,000 and she pays income tax of $6,188. If Melodie’s
taxable income increases to $41,000, she would pay income taxes of $6,438. What is
Melodie’s marginal tax rate?
a. 15.47%
b. 25.00%
c. 15.70%
d. 15.00%
e. Some other amount
LO 12.6
12. Jim has a house payment of $2,000 per month of which $1,800 is interest and real
estate taxes with the remaining $200 representing a repayment of the principal balance
of the note. Jim’s marginal tax rate is 30 percent. What is Jim’s after- tax cost of his
home mortgage payment?
a. $600
b. $540
c. $1,400
d. $1,460
e. Some other amount
LO 12.6
13. Martha owns 300 shares of Singapore Airways stock. Thi s year she spends $4,000 t o
travel to Singapore to attend the annual stockholders’ meeting. While she is there,
Martha relaxes and sees a bit of Singapore. She spends 1 day at the shareholder meet-
ing, 2 days relaxing, and 4 days traveling. Of the $4,000 of expenses, what amount is
deductible for tax purposes?
a. $571 (1/7)
b. $2,857 (5/7)
c. $4,000 (100%)
d. $0
e. None of the above
LO 12.5
14. In which of the following situations does the burden of proof in a tax matter not auto-
matically shift to the IRS?
a. The IRS uses statistics to reconstruct an individual’s income
b. A court proceeding against an individual taxpayer involves a penalty or addition
to tax
c. A taxpayer claims hobby losses
Questions and Problems 12-27
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
d. a and b are correct
e. a, b, and c are correct
LO 12.5
15. Which of the following have privileged communication with a client in a noncrim inal
tax matter?
a. CPAs
b. Enrolled agents
c. Attorneys
d. a and c
e. a, b, and c
LO 12.5
16. The burden of proof remains on the taxpayer for corporations, trusts, and partnershi ps
with net worth exceeding:
a. $1 million
b. $3 million
c. $5 million
d. $7 million
e. Some other amount
LO 12.5
17. Both spouses are responsible, jointly and individually, for paying the full amount of any
tax, interest, or penalties due on a joint return.
a. This does not apply to spouses who have divorced after the return was filed.
b. Spouses are responsible jointly but not individually.
c. Spouses are responsible individually but not jointly.
d. Innocent spouses may be relieved of the liability for tax, interest, and penalties.
e. None of the above
LO 12.5
18. A taxpayer’s rights are explained in:
a. Publication 5
b. Publication 17
c. Publication 556
d. Publication 1
e. None of the above
LO 12.5
19. Taxpayers have the right to have an IRS examination take place at:
a. The IRS office
b. Any city of the taxpayer’s choosing
c. A neutral site
d. A reasonable time and place
e. None of the above
LO 12.5
20. If a U.S. Tax Court agrees with the taxpayer on appeal that the IRS position was
largely unjustified, which of the following is correct?
a. The taxpayer must still pay administrative and litigation costs.
b. The taxpayer may recover administrative but not litigation costs.
c. The taxpayer may recover litigation but not administrative costs.
d. To be eligibl e to recover some of the administrati ve and litigat ion costs, the tax-
payer must have tried to resolve the case administratively, including going through
the appeals process, and must have given the IRS the information necessary to
resolve the case.
e. None of the above
12-28 Chapter 12
Tax Administration and Tax Planning
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.