Chapter 28: Procedure and Professional Responsibility
I. Overview of Federal tax Procedure
A. introduciton
1. When and how can the government exact additional tax that should have been paid and what means are available to the taxpayer? When and how can the taxpayer recover tax that was improperly paid?
B. The Self Assessment System
1. Tax liability is determined initially by the taxpayer, a potentially taxable individual is required to file an income tax return annually and to pay any amount of tax shows on the return to be due.
C. Administration Procedures
1. Tax Audits: it is generally more profitable for the IRS to audit returns reporting large amounts of income, because errors found there may produce much larger amounts of revenue.
a) Correspondence Audits: handled entirely by correspondence
b) Office Examination: conducted in an IRS office
c) Field Office: an Agent actually visits the home or place of business to conduct the audit.
d) Agents are armed with extensive authority to inquire into matters affecting tax liability and with judicial assistance to compel the cooperation of the taxpayer.
2. Civil Deficiency Controversies: after an audit you may receive a no change letter indicating that no changes are required.
a) Or you may receive a 30-day letter if there is a change required and the taxpayer disagrees. The letter states the proposed adjustments and is accompanied by a copy of the examining agent’s report explaining the basis for these proposals. The taxpayer may request an administrative review of issues not settled with the examiner.
b) If the taxpayer pursues administrative procedures, then the government will issue a formal deficiency in the form of a 90-day letter. This gives the taxpayer 90-days to file a petition in the Tax court and during this time the collection and assessment of the tax is barred.
c) Form 870: a form that is an authorized waiver of one’s statutory right to receive a 90-day letter prior to assessment.
d) Form 872: an authorized extension of the limitation period. If the taxpayer refuses to sign this, it is usually more detrimental to the taxpayer, since the IRS will assess the highest tax they think you might be liable for, rather than searching through the records.
e) If, after the 90-day letter, the taxpayer files in tax court, the taxpayer does not have the option of permitting the tax to be assessed, paying it, and then filing for a refund and then a suit in District Court. But the taxpayer can appeal the Tax Court’s ruling.
3. Controversies Involving Fraudulent Claim: A special Agent represents the government and does the interview with the taxpayer being told specific rights they have. If the Special Agent recommends prosecution, a detailed special report is required.
4. Refund Controversies: If the action is timely, the taxpayer can file a refund claim and if the refund is not allowed administratively, then they can sue for a refund.
a) Can also arise if the taxpayer pays the deficiency note and then wants to recover it, thinking they did not have to pay it in the first place.
b) Procedure starts with a refund claim made by an individual on form 1040X or an amended form 1040. After rejection, the taxpayer may then go to the courts, but only after attempting the administrative process first.
5. Administrative finality: the code authorizes the administrative officials to enter into binding agreements with taxpayers with regard to their liability or payment of taxes. Closing Agreement relate to the income tax liability of a taxpayer, they may fix the entire tax liability of a taxpayer for a particular year or they may relate only to one or two issues. Authority to Compromise on tax liability, interest and penalties is granted to the government.
D. Judicial Procedures
1. Deficiency Cases: Once a 90-day letter has been sent out, and the taxpayer has filed a petition within the period, the Tax Court has jurisdiction. Cases are always tried without a jury.
2. Refund Suits: a taxpayer who asserts an overpayment of tax after filing a refund, may file suit in the US District Court for a refund. The suit can also be filed in US Court of Federal Claims.
3. Burden Of Proof: taxpayer generally has to prove that the commissioner’s determination was incorrect and to establish the taxpayer’s claim by a preponderance of the evidence. In any proceeding involving a penalty, the commissioner must initially provide evidence that it is appropriate to apply a particular penalty to the taxpayer before the court can impose the penalty. Unless specified, the commissioner now has the burden of proof with respect to factual issues if certain requirements are met. The burden falls on the commissioner if the taxpayer 1) introduces credible evidence with respect to any factual issues relevant to ascertaining the taxpayer’s tax liability, 2) substantiates any item required to be substantiated by the taxpayer under the code, 3) maintains all record required by the code and 4) cooperated with reasonable requests by the commissioner for witnesses, information, documents, meetings and interviews.
4. Appellate Procedures: the losing party in a deficiency proceeding in the Tax court or in a refund suit in DC or the court of Federal Claims may appeal the decision to the court of appeals. But if in Tax court or in DC, the taxpayer must appeal to the court of appeals for the circuit the taxpayer is in. Whereas if you are in the Federal Claims court, you appeal to the Court of Appeals for the Federal Circuit.
5. Recovery of Taxpayer costs and attorney’s fees: if a taxpayer is the prevailing party in a dispute with the service, the taxpayer may recover both reasonable administrative costs incurred and reasonable litigation costs. Only available where the taxpayer has exhausted his available administrative remedies.
E. Collection of Taxes
1. Regular Collections: After proper assessment, the government has 10 year to collect (this is not assessment).
F. Problems:
1. Taxpayer wants a jury trial – go to district court
2. Taxpayer has no money with which to pay an asserted deficiency – after 90-day letter, request administrative review, then go to tax court, since the tax collection and assessment is put on hold.
3. Taxpayer wishes to stop the running of interest but at the same time litigate the issues – pay the tax then sue for a refund.
4. Litigation involves complex tax law issues – go to tax court since the judges do tax law full time.
5. Split of authority among circuit courts, but the court of appeals in the juris the taxpayer resides has decided the issue in the government’s favor – go to the court of federal claims.
6. If asked to sign a form 872, what should a taxpayer do – usually sign, because otherwise they will issue a 90-day letter assessing higher tax than estimated originally.
II. Special Rules Applicable to Deficiency Procedures
A. Timing Rules, Interest and Penalties
1. Statute of limitations: The service generally must assess any amount of alleged underpayment of a tax within 3 years after filing or 2 years after payment. The period is extended to 6 years if the taxpayer has omitted gross income in excess of 25% of the gross income reported on the return. In the case of a false or fraudulent return or when no return is filed, the statute of limitations does not begin to run and tax may be assessed at any time.
a) Timely-mailed, timely-filed: applies to mail properly mailed with the US postal service or a designated private delivery service. The date on the postmark is designated as the date filed.
Interest and Penalties: Interest runs against the taxpayer from the date the amount should have been paid and with respect to underpayment, interest is equal to the federal short-term rate plus 3%. Penalties for a failure to file a return are 5% of the tax per month and failure to pay the tax due is ½ of 1% of the tax per month. But § 6651(a) says that the total penalty for the failure to file or the failure to pay may not exceed 25% of the tax.
B. Problems:
1. When can the commissioner make an assertion of an income tax deficiency against T for taxes filed…
a) April 1, 2000 – April 15, 2003…this being 3 years from filing time, using the last date due.
b) May 1, 2000 – May 1, 2003…3 years from date filed
c) Never filed a return for 1999 – at any time, there is no statute of limitations.
2. T filed on April 1, 2000, What would happen if…
a) Deficiency asserted rests on the alleged omission of $20,000 of fees which if, reported would have made T’s income be $60,000? If you omit more than 25% of income, then there is a 6-year statute of limitations.
b) The omission is alleged to have occurred due to T’s deliberate attempt to evade tax? Can asses at any time, no statute of limitations.
C. Innocent Spouse Rules
1. If a joint income tax return is filed by a husband and wife, both are generally jointly and severally liable for the tax. An innocent spouse may elect relief when the other spouse made an erroneous understatement of items of which the innocent spouse was unaware, where the spouses are no longer married or living together, or in other situations where equitable relief is justified.
III. Special Rules to Refund Procedures
CHAPTER 2: GROSS INCOME: THE SCOPE OF SECTION 61
I. Introduction to Income
A. Federal Income tax is imposed annually on a net figure known as taxable income, which is gross income less certain authorized deductions. § 61 defines gross income as all income from whatever sources derived.
II. Equivocal Receipt of Financial Benefit
A. Cesarini v. U.S. –
1. Facts: taxpayers purchases a piano for $15 at an auction in 1957, then in 1964 discovered $4,467.00 in old currency. They paid taxes on the money for the year of 1964, paying $836, then later amended to get a refund on the $836. They claimed the money was found under the treasure trove and should be taxed as capital gains, that the money is not included in the § 61 definition of gross income and that the money should be claimed the year the piano was purchased and therefore the statute of limitations has run.
2. Holding: § 61 is not exclusive and is meant to be a broad definition of gross income. The regulations say that treasure trove is taxed as income. The money was reduced to undisputed possession in 1964, and that is the year it should have and was claimed.
B. Old Colony Trust Co. v. Commissioner –
1. Facts: Wood was president of the company and instead of paying him such a high income, they decided to pay his taxes for the year.
2. Issue: Is the payment of tax by another considered to be income?
3. Holding: In effect the company gives the taxpayer compensation for his duties, was in consideration of his duties, although he does not directly receive payment
C. Commissioner v. Glenshaw Glass Co. –
1. Facts: Two cases involving litigation. Basically two companies won settlements for various reasons, receiving punitive damages and treble damages neither of which were claimed as gross income for the taxable year, claiming they were not part of income.
2. Issue: Was the settlement part of income?
3. Holding: Income – an undeniable accession of wealth, clearly realized and over which the taxpayer has complete dominion. Gained derived from labor, capital or both was the old definition.
a) Ex: if you catch a McGuire fly ball, then you have an undeniable accession of wealth, which is clearly realized and which you have complete dominion over, so you pay taxes on the fair market value of the item, the year its clearly realized.
D. Charley v. Commissioner pg. 60
1. Facts: Charley traveled to accident sites to investigate them. There was an agreement with the company that he would bill out first class tickets. Charley in fact purchased coach tickets, used his frequent flyer miles to upgrade then take the difference in the price of the ticket (first vs. coach) as refund from the company. Basically, he gained $3,149 in cash from “selling” his frequent flyer miles to the company.
2. Issue: Should this money be included in gross income?
3. Rule: IRC § 61 provides that gross income means all income from whatever source derived.
4. Holding: the tax court was correct in concluding that the travel credits under the facts of this case constitute taxable income.
5. Reason: the travel credits were Charley’s to use for what ever purpose, he in fact used them in a manner that converted them into cash in a manner equal to additional compensation. Because he received the miles at no cost, he had a basis of zero, then exchanged them for cash in the amount of 3K and therefore had that amount as gain.
E. Note:
1. Loans are based on concurrently acknowledged obligations to repay, which offsetting the receipt, negate any accession to wealth and is not taxable income, as is a security deposit. Income from unlawful means: James: unlawful, as well as lawful gains are compensation within the term gross income, and in the changes to the code, the word “lawful” was specifically left out to mean that income from unlawful means is to be included in income.
F. Problems:
1. What would the result be if the Cesarini piano had been discovered to be a Steinway worth $500,000? Since the Cesarini’s purchased the piano for $15, which was the fair market value of the piano at the time they purchased it, they would have already owned the piano when the price of it increased. When they sell the piano, then they pay the taxes on the income, but not until selling.
2. Winning a $200 valued watch at a store? The Fair market value of the watch is $200 and it’s a clear accession of wealth.
3. Employee receives 2% of company stock, value of $20,000, a new car for the spouse worth $15,000 in exchange for the employee not leaving the company. What is the realized gain in this transaction? Employee gets income in the amount of the car and the amount of pay. Even though the car is given to the spouse, its still indirect income.
4. Insurance adjuster refers clients to an auto repair firm that gives the adjuster kickbacks of 10% of the billing referrals. A) Does adjuster have gross income? Yes, its income. B) Even if it violates local law? Yes, even though it violates the law, its still income.
5. Owner agrees to rent tenant a house for the summer for $4,000. A) How much income does owner realize if she agrees to charge tenant only $1,000 if T makes $3,000 in improvement? The landlord will have $4000 in income since he receives the value of the services instead of the rent. B) What if T does all the labor himself at a cost of $500? LL still has $4000 in income. C) Does T have any tax consequences in B? Tenant receives a discharge of his obligation to pay rent by doing the improvements, thus he has income in the amount of $2500 ($3000 – $500). Think of this in terms of an exchange of cash
6. Flyer receives frequent flyer miles, do they have gross income…A) flyer receives miles as part of personal trip, miles are assignable? When only looking at § 61, the miles are part of what he paid for and it’s not a separate event. B) Receives miles from employer for business flights F takes for employer, miles are assignable? In theory the miles are taxable since the employer purchased the ticket and thus the miles, but the IRS has not yet taxed the miles. C) Same as B but miles are nonassignable? There is no value to the miles and there is no income. D) Same as C but F takes a personal trip with miles? Again, it possible to tax this, but the IRS has not yet done so.
II. Income without Receipt of Cash or Property
A. Regs § 1.61-(2)(a)(1), -2(d)(2)(i)
B. Helvering v. Independent Life Ins. Co. –
1. Rental value of the building used by the owner does not constitute income within the meaning of the 16th Amend.
C. Dean v. Commissioner –
1. The corporation, run by H and W, holds the title to the home that taxpayer and spouse lives in.
2. Issue: When the corp. owns the home the Taxpayer lives in “rent free,” should the taxpayer claim the rent as income?
3. Holding: The fair rental value of the property was income to the taxpayer.
4. Reason: the taxpayer receives a value by living in the home rent-free. If he did not live in that home, he would have to pay rent or a mortgage and by not having to pay it, he receives income from it.
D. Problems:
1. Vegy grows vegetables in her garden, does she have gross income when: A) she harvests her crop? No. B) Her family consumes $100 worth? No, this falls under the imputed income category where you use your own services for your own benefit. C) She sells them for $100? By selling the veggies, she gets income, which can be offset by the expenses in growing. D) She exchanges them for $100 worth of tuna from Charley? Each would have $100 in income since its an exchange of services
2. Doctor needs to have his income tax prepared; Lawyer would like a general check up. Each would normally charge $200 for their services, what effect on income if they swap services? Each has $200 income, again, exchange of services. Does lawyer receive any income if she does her own taxes? No.
CHAPTER 3: THE EXCLUSION OF GIFTS AND INHERITANCES
I. Rules of Inclusion and Exclusion
A. IRC § 102 (a) and (b); Regs § 1.102-1(a) and (b)
B. §§ 71-90 say what is partially includ
the same line of business as that in which the employee is performing services, the employer incurs no substantial additional cost in providing the service to the employee and in the case of highly compensated employees, the services are provided on a nondiscriminatory basis.
2. § 132(a)(2): Qualified Employee Discounts: exclude the value of courtesy discounts on items purchased from employer for use by the employee as long as the same-line-of-business and the nondiscrimination limitations are meet. The discount can be taken as either a price reduction or a rebate. There is a ceiling on the amount of the exclusion. For Services, the exclusion may not exceed more than 20% of the price at which the services are offered by the employer to customers. The maximum discount for property is essentially the employers gross profit percentage on goods in the employee’s line of business (aggregate sales price reduced by cost)/(aggregate sale price)
3. § 132(a)(3): Working Condition Fringe: exclusion for any property or services provided to an employee the cost of which if the employee had paid for the property or services, would have been deductible by the employee as a business expense or by was of depreciation deductions.
4. § 132(a)(4): De Minimis Fringe: any property or service whose value is so small as to make required accounting for it unreasonable or administratively impracticable is excluded as a fringe benefit. Bargains at employer-operated eating facilities will be treated as de minimis fringes if they are located on or near the employer’s business premises and the revenue generated from their operation normally equals or exceeds their operating costs.
5. § 132 (a)(5): Qualified Transportation Fringe: includes the value of benefits provided in a commuter highway vehicle between an employee’s residence and place of employment; a transit pass etc., and qualified parking provided on or near the business premises or on or near the location from which employee is picked up by a commuter vehicle.
6. § 132(j)(4): Athletic Facilities: employee may exclude from GI the value of the use of any on-premises athletic facility, if substantially all the facility’s use is by employees, their spouses and their dependent children.
7. Statutory Exclusions of other fringe benefits: § 132 provides that if another code section provides an exclusion for a type of benefit, § 132 is generally inapplicable to that type, an ad hoc provision prevails over the general rules of § 132.
C. Problem:
1. Employee of national hotel chain stays in one of the chain’s hotels in another town rent-free while on vacation. The hotel has several empty rooms. The price of the hotel room is not included in GI under § 132(a)(1), assuming the benefit is non discriminatory and employee is not highly compensated.
2. Same as above, except that the desk clerk bounces a paying customer so employee can stay rent-free. By excluding a paying customer, the employer sustains additional costs and the price of the room is included in income for the employee. But under the regs, 20% of the room can be discounted and thus 20% can be excluded from income, the remaining 80% of the room is included.
3. Same as 1, except employee pays the bill and receives a cash rebate from the chain. The rebate is not included in income.
4. Same as 1, except employee’s spouse and dependent children traveling without employee use the room on their vacation. The spouse and child are included in the concept of the employee so their stay is also not included in income.
5. Same as 1, except employee stays at a rival chain under a written reciprocal agreement under which employees pay 50% of the normal rent. The 50% payment is not income since there is the reciprocal agreement between the chains. § 132(i) applies to no additional cost services.
6. Same as 1, except that an employee is an officer in the hotel and rent-free use is provided only to officers of the chain and all other employees pay 60% of the normal rent. Since the benefit is not given to all employees in a fair manner, and the officer is presumably a highly compensated person the price of the room is included in income. They also cannot get 40% deduction to match the 60% payment that other employees would have to pay, the highly compensated employee has to include the full amount as income.
7. Hotel chain is owned by a conglomerate which also owns a shipping line. Same as 1, but employee works for the shipping line. Since the employee must work in the line of business, the employee will not get the exclusion.
8. Same as 7, except employee is comptroller of the conglomerate. As long as the employee is substantially providing services for both divisions of the company, then the amount is excluded from income.
9. Employee sells insurance and employer insurance co. allows employee 20% off the $1,000 cost of the policy. The employee would not include the 20% of the $1000 in income. This job provides a service and the employee receives a discount, which can be excluded.
10. Employee is a salesman in a home electronics appliance store. During the year the store has $1mil sales and a $600K cost of goods sold. Employee buys a $2000 videocassette recorder from employee for $1000. Must determine the gross profit percentage allowed by taking the 1mil – 600K all divided by 1 mil, this leaves you with 40%. So 40% of the price discounted. Here 40% of $2000 is $800, which can be excluded from income. The employee received $1000 in discount and must claim $200 of the $1000.
11. Employee attends a business convention in another town. Employer picks up employee’s costs. Had the employee paid for the trip, he would have been able to deduct it and thus by having the employer pay for it, its still not income for the employee.
12. Employer has a bar and provides the employees with happy hour cocktails at the end of each workweek. Since the wording here is every workweek and the regs permit occasional, you must look at the norm for the industry and the possibility of accounting of the fringe, as well as cases to determine this.
13. Employer gives employee a case of scotch each Christmas. Traditionally, gifts of low FMV are considered to be de minimus fringe, but as long as the gift is not disguised compensation, then its deductible.
14. Employee is an officer of the corp. which pays employee’s parking fees at a lot one block from the corp. headquarters. Nonofficers pay their own parking fees. Assume no post 1993 inflation. The parking fees are excludable from income, assuming the parking is near the work place and it does not exceed $175 per month, anything over $175 is included in income.
15. Employer provided employee with $900 worth of vouchers for commuting on a public transit system during a year prior to 2002. A total of $65 per month is excludable, so 65 x 12 = $780 of the $900 can be excluded, but the remaining amount is to be included in income.
16. Employer put in gym at the business facilities for the use of the employees and their families. The use of the gym facilities is excludable, however the employer cannot give a gym membership, the employer must own the gym and it must be on the premises.
II. Exclusions for Meals and Lodgings
