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ACCT324 MIDTERM EXAM TOPICS

I.

IRS-Penalties and the Audit Process

A. Which taxpayers are most likely to be audited and why-pg. 1-19


Although the IRS audit targets change with the times, below you'll find some helpful hints as to which tax areas have commanded the IRS' audit attention in recent years. There are a host of strategies you can use to ensure you aren't selected for an IRS audit.

The High-Risk Tax Audit Areas The odds are low that your tax return will be picked for an IRS audit. The IRS does not have sufficient personnel and resources to examine every tax return, so the IRS selects those tax returns which, upon preliminary inspection, have high audit potential -- those that are most likely to result in a substantial tax deficiency. In recent years, less than 2% of all individual income tax returns have been audited. However, your chances for an IRS audit are higher depending upon certain types of income, certain amounts of income, your profession, the types of transactions, and the types of tax deductions claimed on your tax return. High-Risk Tax Audit Areas - High Wages Generally, as your income increases, so does your chance of an IRS audit. The odds of an IRS audit for someone in the $25,000 to $100,000 income bracket are less than one in 100. For those making more than $100,000, the odds increase to more than one and one half in 100. Your chances of being audited by the IRS are greater under the following circumstances: You have large amounts of itemized deductions on your tax return that exceed IRS targets. You claim tax shelter investment losses on your tax return. You have complex investment or business expenses on your tax return. You own or work in a business which receives cash and/or tips in the ordinary course of business. Your business expenses are large in relation to your income on your tax return. You have rental expenses on your tax return. A prior IRS audit resulted in a tax deficiency. You have complex tax transactions without explanations on your tax return. You are a shareholder or partner in an audited partnership or corporation. You claim large cash contributions to charities in relation to your income on your tax return. An informant has given information to the IRS. You must report all your income, and you should take all your tax deductions, even if they increase your chances for an IRS audit. Don't be scared off by these factors. However, also realize that your chances for an IRS audit do increase with certain tax items, and prepare your tax return accurately and completely. High-Risk Tax Audit Areas - Large Amounts of Itemized Tax Deductions If your itemized tax deductions on your tax return exceed a target range as set by the IRS, the chances of being audited by the IRS increase. This does not mean that you should not take tax deductions on your tax return that you are entitled to, but you should realize that your chances for an audit increase if your tax deductions exceed the averages for your income level. Another issue to consider is excessive itemized tax deductions on your tax return. The IRS doesn't describe the criteria by which it determines when tax deductions are excessive. Some tax experts calculate average tax deductions by income, and use these figures as a rough benchmark to determine if a taxpayer's tax deductions on his/her tax return

exceed the norm. Tax experts caution that these averages may not be useful, since tax deductions vary widely by state and region. And the medical tax deductions, for instance, would by definition be much higher than the average taxpayer would take because the IRS data reflect cases where taxpayers had medical deductions exceeding 7.5% of their taxable income. You should take valid tax deductions on your tax return if they are amply backed up. High-Risk Tax Audit Areas - High DIF When your tax return is filed, IRS computers compare it against the national Discriminate Information Function (DIF) system average. The IRS calculates the DIF score by using a closely-guarded formula. Tax returns with the highest DIF scores are scrutinized by experienced IRS examining officers who determine which tax returns provide the best chance for collecting additional taxes, interest, and tax penalties. High-Risk Tax Audit Areas - Unreported Taxable Income Unreported taxable income is a common red flag. The IRS discovers unreported taxable income when its computers match the taxable income you reported on your tax return with information gathered from banks and others. For example, if you failed to report on your tax return the interest earned on your bank savings account, the IRS typically will catch you when it matches the bank's interest payment records, called 1099 forms, against your tax return. One good way to make sure you don't miss unreported taxable income is to review last year's tax return to make sure you have 1099's, etc. from mutual funds, banks and other sources. The IRS electronically matches the figures you report for dividends, interest, securities transactions and other taxable income with tax information supplied by banks, brokerage firms, and other payers. To avoid problems, it's best to report your dividend and interest income exactly as it appears on your 1099 forms and make adjustments on the tax return if the numbers are incorrect. If your brokerage account files a 1099 for all your dividends, don't list separate amounts on your tax return. By the same token, if you receive separate 1099s, don't report your taxable earnings in one lump sum. High-Risk Tax Audit Areas - Self Employment Because the IRS believes most under-reporting of taxable income and abuse of tax deductions occurs among those who are self employed, these individuals are audited by the IRS far more frequently than employees collecting a salary. The same holds true for taxicab drivers, waiters and waitresses, and others who traditionally receive payment in cash. Also, the IRS will sometimes conduct tests of certain individuals to determine if a taxpayer's reported taxable income can support his or her lifestyle. The IRS publishes manuals to familiarize its auditors with about 100 different businesses, particularly ones that have a high number of self employed individuals. These guides, which are available to the general public, can help you pinpoint what auditors are looking for and how best to protect yourself. To learn if a guide is available for your business click here: Audit Guides or call the IRS Freedom of Information Act Reading Room at (202) 622-5164, or write Box 795, Ben Franklin Station, Washington, DC 20044. High-Risk Tax Audit Areas - Home Office Tax Deductions Home office tax deductions have been targeted by the IRS. Since the tax rules for deducting home office expenses on your tax return are complicated, you should consult a tax expert, such as a CPA, to determine whether you qualify to deduct home office expenses on your tax return. A good example is the office in the home. By claiming such an item on your tax return, you increase your chances for an IRS audit. However, if you're clearly entitled to claim the office in the home on your tax return under the tax rules, then you should do it if it's substantial enough to make a tax difference. However, if the tax savings are minimal, then it may be wise not to claim the tax deduction at all.

High-Risk Tax Audit Areas - Unreported alimony Over the years, the IRS has found that not all taxpayers report alimony receipts as taxable income. As a result, the IRS now matches tax deductions for alimony payments by one former spouse with the taxable alimony income reported by the other. High-Risk Tax Audit Areas - Automobile Logs One of the biggest and most commonly audited items by the IRS for individuals in their own business, and employees of companies who use their car in business, is the tax deduction for business transportation. It is important that you keep good records of all tax deductible automobile expenses and a mileage log showing business miles driven. Also, try to keep a daily log of business mileage. Ideally, such log would show the date, beginning and ending odometer readings, the location, the business purpose, and the client. Such detail is hard for today's business person to keep, but it's important to have something in writing in case you're audited. At a minimum, make sure you write down the automobile's odometer reading at the beginning and the end of the tax year and have a daily record that you could go back to and use to reconstruct a claimed business mileage tax deduction on your tax return. Self-defense pays off You should take every tax deduction you're entitled to on your tax return, and you should not be frightened by the potential of an IRS tax audit. However, you must exercise common sense and weigh the risk you are taking by claiming or using certain tax deductions on your tax return with the reward that you receive in terms of tax savings. Don't be frightened by the chance for an IRS tax audit since it is slight, but also don't randomly increase your chances for an IRS tax audit with items that have minimal tax benefit to you. Use your own judgment and common sense along with the advice of your tax professionals. CPAs say the best way to avoid a tax audit is to file a complete and accurate tax return. Double check your math, and make sure you have used the correct IRS tax forms and IRS tax schedules. And if you think the IRS may question a large tax deduction or tax credit, attach an explanation to your tax return when you file it.

B. What are the characteristics of the audit process pg. 1-19-20


High-Risk Tax Audit Areas - High DIF When your tax return is filed, IRS computers compare it against the national Discriminate Information Function (DIF) system average. The IRS calculates the DIF score by using a closely-guarded formula. Tax returns with the highest DIF scores are scrutinized by experienced IRS examining officers who determine which tax returns provide the best chance for collecting additional taxes, interest, and tax penalties.

C. What are the penalties associated with a late return- pg 1-22 D. What are the characteristics of fraud penalties- pg 1-23
Fraud involves specific intent on the part of the taxpayer to evade a tax. In the case ofcivial fraud, the penalty if 75% of the underpayment attributable to fraud. Criminal fraud, the penalities can include larges fines as well as prison sentences

E. What tax provisions justify promoting IRS administrative feasibility pg 1-32

II. General Background of the Taxation System

A. What is the wherewitheal to pay concept- pg 1-29


Recognizes the inequity of taxing a transaction when the taxpayer lacks the means with which to pay the tax. It is particularly suited to situations in which the taxpayers ecnomonic position has not changed significantly as a result of the transaction.

B. When was the IRS law originally codified- pg 2-2


Tax codified in 1939

C. What is the process by which tax bills are originated and passed through
Congress- pg 2-3 & pg2-5 Tax bills originate in the Senate when they are attaches riders to other legislative proposals..

D. Where are Subchapter S corporation tax rules located- pg 2-4


(Tax Treatment of S Corporations and Their Shareholders)

E. How are sections/subsections of the Tax code designated-pg2-6 F. What is the impact of tax treaties on the tax code- pg 2-20

III. Analysis of a tax return

A. What are the criteria for determining filing status pg 3-24-28


1. E.g., when does someone qualify for head of household, married filing jointly, married filing separately

IV. Calculations of income by accrual vs. cash basis accounting taxpayers pg 4-9
Accural method- an item is generally included in the gross income for the yr in which it is earned. Regardless of when the income is collected. Income Earned when: 1) all the events have occurred that fix the right to receive such income and 2) the amt to be recvd cn be determined w/reasonable accuracy.

Cash basis- property or srvcs are included in the taxpyrs gross income in the yr of actual or constructive rcpt by taxpayer or agnt, regardless of whether the income was earned in that yr. Deters income recognition until the account rcvable is collctd.

A. E.g. Rental income, gym memberships, advances paid by customers, prepaid


income, retainers

V. Inclusions/exclusions from incomeExclusions from income pg 3-4 & 5-4 Inclusions- pg-3-5 Specific Items of Income (Inclusions)

Earned Income

Wages/salaries/other benefits of employment are generally presumed to be taxable income. Anything of value that flows from the employer to the employee, unless specifically excluded in the tax code, is taxable.

Income obtained as a partner or as an independent contractor is taxable in addition to income received as an employee.

Scholarships, which can be viewed as a form of "earned" income, are generally taxable.

Passive Income

Taxable income is not derived exclusively from the active participation of taxpayers. Taxable income can arise from passive income sources as well.

Income from investments, such as dividends and interest, is taxable. Prizes are also generally taxable, as are unemployment benefits. Tax refunds from prior years can be taxed in the year of receipt, as well as social security benefits and disability payments.

A. The value of meals per Section 119 Pg 5-17 Section 119 excludes means from income the value of meals and lodging provided to the employee, spouse and dependents; -the meals and or lodging are furnished by the employer, on the employers business premises for the convenience of the employer.

B. Lodging per Section 119 pg 5-17


- - In the case of lodging, the employee is required to accpt the lodging as a condition of employment.

C. Employer Reimbursement for meals D. Group insurance p 5-15

VI. Allowance for deductions p 6-3 Wk3

A. Deductible expenses related to vacation homes

B. Cost recovery deduction, e.g., automobiles-See Ch. 8 examples 24, 27


C. Calculation of rental income/loss related to rental home D. Deductibility of debt obligations of a dependent E. Deductibility of charitable deductions of a dependent F. Deductibility of legal expenses

VII. Computations of losses wk3 pg 7-8


A. Personal casualty losses, e.g., automobiles accidents, house fires

VIII.

Charitable donation deductibility wk4 pg 10-19 A. Donating investment property B. Donating stock C. Donating clothing D. Donating cash E. Donating land

IX. At risk rules applicable to passive activities p 11-20 A. Be able to calculate suspended passive loss Taxpayers should not forget the existence of suspended passive losses that were not deductible in earlier years. These passive losses can be valuable in the event that passive income is generated in later years or if passive activities are disposed of. One strategy that could be adopted to maximize the use of these carry forwards would be to consider a sale of passive assets to free up some of the losses. Interaction of the At-Risk and Passive Activity Limits The at-risk rules are applied before determining the amount of losses suspended under the passive loss rules. Vacation homes generally are subject to the passive activity rules if they are held for the production of rental income and not classified as a second residence. As a result, when the owner of such rental property makes plans regarding its operations (for example, renting, financing, and selling such vacation property), the impact of the passive loss rules must be considered. One tax break that may be available for some taxpayers is the opportunity to deduct up to $25,000 of rental losses against ordinary income. Losses that are not deductible in a particular year because of the passive loss rules, however, are suspended until future years. Dispositions of Passive Interests Suspended losses on a passive activity transferred at death are allowed to the decedent to the extent that they exceed the step-up in basis for the property.

B. Review Examples 36 to 39, chapter 11

X. Application of the installment method

A. When does it apply p 4-8


A taxpayer may choose to spread the gain from an installment sale of property over the collection periods. Contractors may either spread profits frm contracts over the periods in which the work is done ( the % of completion method) or deter all profit until the year in which the work is done (the completed contract methodcan only be used only in limited circumstances)

B. Calculation of gain/loss pg 11-24

XI. Other

A. Computation of the gross profit percentage


http://www.valuebasedmanagement.net/methods_gross_profit_percentage.ht ml B. What do social and economic factors justify

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