Tax Update For The 2011 Annual Conference for Women in Accounting Prepared by

1. Tax Update For The 2011 Annual Conference for Women in Accounting Prepared by By Howard Godfrey, Ph.D., CPA Professor of Accounting – UNC Charlotte October 25, from 1:40 to 3:20 pm.

2. Part 7 Uncertainty in Tax Practice: Economic Substance, Uncertain Positions

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5. Unrecognized tax benefits-Duke Energy Duke Energy reported total Unrecognized Tax Benefits of $664 million as of January 1, 2010. The balance declined to $342 million by the end of the year, primarily due to settlements of $320 million. Form 10-K. December 31, 2010.

6. Unrecognized tax benefits- Walmart At January 31, 2010 and 2009, the company had an unrecognized tax benefit of $1.7 billion, which is related to an ordinary worthless stock deduction from the fiscal 2007 disposition of its German operations… If …the ordinary loss is determined to be a capital loss, the resulting deferred tax asset will be included with the company’s non-current assets of discontinued operations. In addition to amounts shown … (above), $1 billion of unrecognized tax benefits are considered uncertain tax positions and have been recorded as liabilities.

7. Unrecognized tax benefits- Walmart As of January 31, 2010 and 2009, the amount of unrecognized tax benefits related to continuing operations was $1.0 billion, of which, the amount of unrecognized tax benefits that would affect the company’s effective tax rate is $671 million and $582 million for January 31, 2010 and 2009, respectively. Accrued penalties totaled $2 million at January 31, 2010 and 2009.

8. Unrecognized tax benefits- Walmart During the next 12 months, it is reasonably possible that tax audit resolutions could reduce unrecognized tax benefits by between $350 million and $500 million, either because the tax positions are sustained on audit or because the company agrees to their disallowance. The company does not expect any change to have a significant impact on its results of operations or financial position.

9. Reporting Uncertain Positions 1 Tax positions to be reported. Schedule UTP requires the reporting of each U.S. federal income tax position taken by an applicable corporation on its U.S. federal income tax return for which two conditions are satisfied. 1. The corporation has taken a tax position on its U.S. federal income tax return for the current tax year or for a prior tax year. 2. Either the corporation or a related party has recorded a reserve with respect to that tax position for U.S. federal income tax in audited financial statements, or the corporation or related party did not record a reserve for that tax position because the corporation expects to litigate the position.

10. Reporting Uncertain Positions 2 A tax position for which a reserve was recorded (or for which no reserve was recorded because of an expectation to litigate) must be reported regardless of whether the audited financial statements are prepared based on U. S. generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS), or other country-specific accounting standards, including a modified version of any of the above (for example, modified GAAP).

11. Reporting Uncertain Positions 3 A tax position taken on a tax return is a tax position that would result in an adjustment to a line item on that tax return if the position is not sustained.

12. Part 8 Standards Applicable to Taxpayers & Tax Preparers

13. The following slides will be helpful as background before we analyze code sections 6662 and 6694, and related court cases

14. Part 9 Penalties - Taxpayer & Preparer - Code Provisions IRS is placing greater emphasis on collecting penalties from taxpayers and tax preparers. What are some penalty rules? How are they applied in some actual cases - situations?

16. Accuracy-related penalty (1) An accuracy-related penalty under section 6662 applies to the portion of any underpayment that is attributable to (1)negligence, (2)substantial understatement of income tax, (3)substantial valuation misstatement, (4)substantial overstatement of pension liabilities, or (5)any substantial estate or gift tax valuation understatement.

17. Accuracy-related penalty (2) If correct income tax liability exceeds that reported by taxpayer by the greater of10% of correct tax or $5,000 [or, in case of corporations, by the lesser of (a) 10 percent of the correct tax (or $10,000 if greater) or (b) $10 million], then a substantial understatement exists and a penalty may be imposed equal to 20% of the underpayment of tax attributable to the understatement.

18. Accuracy-related penalty (3) Section 6662 penalty is increased to 40 percent in the case of gross valuation misstatements. Except in the case of tax shelters, the amount of any understatement is reducedby any portion attributable to an item if: (1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment. The Treasury Secretary may prescribe a list of positions which …do not meet the requirements for substantial authority under this provision.

19. Sec. 6694.Understatement of Taxpayer's Liability by Tax Return Preparer. (1) (a) Understatement Due to Unreasonable Positions. (1) In general. If a tax return preparer (A) prepares a return … understatement of liability is due to a position described in paragraph (2), and (B) knew (or reasonably should have known) of the position, such tax return preparer shall pay a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

20. Sec. 6694.Understatement of Taxpayer's Liability by Tax Return Preparer. (2) (2) Unreasonable position. (A) In general. Except as otherwise provided in this paragraph, a position is described in this paragraph unless there is or was substantial authority for the position. (B) Disclosed positions. If the position was disclosed … and is not a position to which subparagraph (C) applies, the position is described in this paragraph unless there is a reasonable basis for the position. (C) Tax shelters and reportable transactions. If the position is with respect to a tax shelter … or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits. (

21. Sec. 6694.Understatement of Taxpayer's Liability by Tax Return Preparer. (3) (3) Reasonable cause exception. No penalty shall be imposed … if ..there is reasonable cause for the understatement and tax return preparer acted in good faith. (b) Understatement Due to Willful or Reckless Conduct. (1) In general. Any tax return preparer who prepares any return … part of an understatement of liability is due to a conduct described in paragraph (2) shall pay a penalty … in an amount equal to the greater of- (A) $5,000, or (B) 50 percent of the [preparer’s fee] ... (2) Willful or reckless conduct. Conduct described in this paragraph is conduct by the tax return preparer which is— (A) a willful attempt in any manner to understate the liability for tax on the return or claim, or (B) a reckless or intentional disregard of rules or regulations.

22. IRM 20.1.6.2.1(02-08-2008). Referral to the Office of Professional Responsibility- Cross Reference IRM 4.32.2.12.4.2 When the following penalties are asserted against a practitioner, an information referral to the Office of Professional Responsibility (OPR) is mandatory: IRC section 6694(a), Understatements Due to Unrealistic Positions, and IRC section 6694(b), Willful or Reckless Conduct, penalties when closed agreed by examiners, sustained in Appeals, or closed without Appeal contact. IRC sections 6695(f), Negotiation of Check. IRC section 6700 and IRC section 6701, penalties when proposed. A referral is discretionary for IRC section 6695(a) through (e) penalties. Normally referrals will be made if there are a number of similar penalties asserted against the same practitioner, because this could indicate reckless conduct or lack of competence.

23. IRM 20.1.6.2.1(02-08-2008). Referral to the Office of Professional Responsibility- Cross Reference IRM 4.32.2.12.4.2 Federal courts have the authority to permanently prohibit individuals from practicing before the IRS. This usually results from an IRC section 6700 or IRC section 6701 investigation. Examiners assigned promoter investigations should contact the Office of Professional Responsibility and coordinate any additional actions with it. Section 10.53(a) of Treasury Department Circular No. 230 requires Service employees to make a written report to the Office of Professional Responsibility when there is reason to believe that a tax practitioner has violated the rules in the Circular. When disciplinary action is deemed appropriate, the report will include sufficient detail, documentation, and exhibits to substantiate the character and extent of the violation.

24. Part 10 Illustrative Cases - You Decide if Penalties Apply

25. The following slides will help us get started with our discussion of uncertain positions and penalties.

26. Jerry R. and Joyce R. Jacks Taxpayer bought a used (5 years old) CAT loader for $40,000 (cost of new one was $530,000). After using the CAT loader for 6 years, the transmission gear malfunctioned. Taxpayer bought for $17,500 a used transmission, which was not rebuilt or reconditioned. A rebuilt or reconditioned transmission would have cost much more than $17,500. The guarantee stated only that it would function properly when installed. The operation of the used transmission after its installation was not covered by any warranty. Taxpayer deducted the cost as repair expense. IRS: must be capitalized. Understatement penalty of about $2,000. What do you say? See. Sec. 6662.

27. Stephen Woodsum received income of about $33 million that was reported on over 160 different information returns. Woodsum gave the information returns to the experienced accountants at his accounting firm. For unknown reasons, the approximately $3.4 million of income from one Form 1099-MISC was not included in the 115-page individual return the firm prepared for Woodsum. Woodsum met with the tax firm to review the return. He did not compare or match the items of income reported on the Form 1040 with the information returns. Result at IRS: deficiency of $521,47 and an accuracy-related penalty [Sec. 6662(a)] of $104,295. Woodsum argued he was not liable for the penalty because he had a reasonable cause for the omission and had acted in good faith, based on his reliance on a professional tax firm to prepare his return. See Sec. 6662 and Sec. 6694.

28. Sidney Dove operated Sid's Tax. He prepared about 700 income tax returns in 3 years. IRS examined 79 of the returns and assessed additional tax for all but one, totaling $610,000. Dove prepared a return for an undercover agent which included education credits that the agent would not have been entitled to under the tax code. Dove said he routinely deducted 10% of a client's income as a charitable contribution without determining whether his customer had documentation to support such a deduction. Dove said he would report whatever information his customers told him without requesting any documents to support their oral representations.

29. Donation of Home to Fire Deparment Taxpayers paid $600,000 for a 3-acre lakefront property, which included a house (lake house), a detached garage, a boathouse, and a well and septic system. The lake house, originally built in approximately 1900, was a 1 1/2-story structure with 3,138 square feet of living space, including a stone facade addition that was constructed in the 1950s. The lake house was in good condition. The County assessed the lake property at $460,100, ($323,000 for land and $137,100 for improvements). They donated house to fire department for training (burn it as part of training). Claimed charity deduction of $76,000 later amended to be $235,350. Will build new house. IRS View: No Deduction. Owe additional tax of $19,940 and an accuracy-related penalty equal to 20 percent of the underpayment under section 6662(a). More facts on next slide.

30. Continued. Mr. Larkin (appraiser) determined the value of the lake property with all improvements to be $675,000, on the basis of a comparison to the direct sales of comparable properties. He then subtracted from this amount: (i) The value of the land (estimated at $550,000 on the basis of direct sales of comparable vacant land), (ii) the value of the structural improvements other than the lake house (estimated at $29,000 on the basis of their replacement cost less physical depreciation) and (iii) certain site improvements estimated at $20,000. By subtracting $599,000 from the market value of the lake property with all improvements ($675,000), Mr. Larkin arrived at what he considered the “contributory value” of the lake house: $76,000, as of December 20, 1997. Mr. Larkin also estimated that the reproduction cost of the lake house was $235,350.

31. Donald Trask owns more than 30 rental properties, acquired over the last 25 years. Last year he spent $134,863 for repairson these rental properties (and claimed deductions for $134,863). The IRS maintains that 78 percent of the amount claimed for these repairs may be immediately deductible and 22 percent should be capitalized. The IRS wants additional tax and a penalty of 20% of the underpayment. (Accuracy related penalty under sec. 6662).

32. Bantom Leasing (Trucking)-1 Shanda Douglas is the sole owner and officer of Bantam Leasing. Charles Douglas is an employee of Bantam, which operates an over-the-road trucking business. They filed a joint Federal income tax return for the year. Roughly 75 percent of Bantam's business is classified as “critical timing” delivery services. Punctual dispatch of cargo is important as Bantam's accounts could be placed in jeopardy should Bantam fail to deliver on time.

33. Bantom Leasing (Trucking)-2 Mr. Douglas believed an aircraft would minimize the risk of losing customers on account of tardy delivery, by quickly replacing drivers who become ill or who are unable to continue on a route. Mr. Douglas consulted his C.P.A., Elaine Simmons, about the tax aspects of purchasing an aircraft. Bantam purchased a Cessna 172 aircraft for $135,000, and it reported this purchase on Form 4562, Depreciation and Amortization, as an item which Bantam elected to expense under section 179 up to the statutory maximum of $125,000. Bantam also deducted costs of $10,580 associated with upkeep and storage of the aircraft.

34. Bantom Leasing (Trucking)-3 They reported a sec. 179 deduction as flowing through to personal Form 1040. Form 4562 was attached to Bantam's Form 1120S, U.S. Income Tax Return for an S Corporation, which was prepared and signed by C.P.A. Elaine Simmons. Mr. Douglas began taking flying lessons. By the end of the tax year Mr. Douglas had advanced to FAA certification with a student license.

35. Bantom Leasing (Trucking)-4 The aircraft was never used for transporting replacement drivers or for any other Bantam business activity in the year. No employees or officers of Bantam held a pilot's license that would have enabled them to use the aircraft to transport a replacement driver. The sole use of the aircraft was for Mr. Douglas' flying lessons.  IRS: deficiency of $44,625. Accuracy-related penalty of $8,925 [Sec. 6662(a)].

36. Ringgold Telephone - 1 Ringgoldwas a C corporation until it elected S status on 1-1-2000. When S status was elected, it owned a 25% partnership interest in Cellular Radio of Chattanooga. A built-in gain (BIG) would apply to the 25% partnership interest if it had a value greater than basis when S status was elected. BIG is a corporate level tax that is paid when the asset is sold.

37. Ringgold Telephone - 2 In 1999, a CPA firm valued the 25% partnership interest at $4,600,000, but revised that value to $2,600,000 later based on more current financial data.

38. Ringgold Telephone - 3 BellSouth bought the interest on 7-6-2000 for $5,220,423. IRS said it was worth $5,220,423 on 1-1-2000, when the election of S status was effective. The court considered various valuation reports and found that the value was $3,727,142on 1-1-2000.

39. Ringgold Telephone - 4 The IRS assessed a deficiency of $925,260and a penalty under Sec. 6662(a) of $185,602based on a value of $5,220,423. (The assessment and penalty would need to be reduced due to the court finding a lower value.) Should the court agree with the IRS and impose the 20% penalty on Ringgold? A penalty on the CPA?

40. Recovery Group - 1 Recovery Groupredeemed stock owned by a 23% stockholder, and also paid him $400,000 for a 1-year non-compete agreement. Donald Troy, a CPA and tax specialist with the accounting firm (BS in Accounting and Masters of Taxation) conducted tax research to determine how to write-off the cost of the covenant. He consulted case law, statutory law, legislative history and regulations. He advised the company to write off the cost of the covenant over the 12-month non-compete period.

41. Recovery Group - 2 The IRS determined that the payment to the retiring owner for the non-compete agreement was in connection with acquiring an interest in a business, and should be amortized over 15 years under Section 197.

42. Recovery Group - 3 The IRS determined that the corporation owed additional tax based on the reduction in the tax deduction for the cost of the covenant, and determined that a 20% penalty should be imposed on the taxpayer. Did the company have a "reasonable basis" for its position on the return (which would be adequate to avoid the penalty if the company provided substantial disclosures about the transaction)?

43. Recovery Group - 4 If the company did not provide adequate disclosure, does it meet the higher standard of "substantial authority" for its position? (What is the difference between "reasonable basis" and "substantial authority?") Did the company have reasonable cause for the understatement on its return? Should the court uphold the 20% penalty on the taxpayer. Should the accounting firm be penalized?