Questions
Chapter 1:
1. Regarding the statute of limitations on additional assessments of tax by the IRS,
determine the applicable period in each of the following situations. Assume a
calendar year individual with no fraud or substantial omission involved.
a. The income tax return for 2020 was filed on February 19, 2021.
b. The income tax return for 2020 was filed on June 25, 2021.
c. The income tax return for 2020 was prepared on April 4, 2021, but was never
filed. Through some misunderstanding between the preparer and the taxpayer,
each expected the other to file the return.
d. The income tax return for 2020 was never filed because the taxpayer thought
no additional tax was due.
Answer:
a. The normal three-year statute of limitations will begin to run on the original due
date of the return (usually, the fifteenth day of the fourth month after year-end; April
15). April 15, 2024
b. Now the statute of limitations starts to run on the filing date. If the date of filing
controlled (see part a. above), the taxpayer could shorten the assessment period by
filing late. June 25, 2024
c. If a return that is due is not filed, the statute of limitations does not start to run. It
does not matter that the failure to file was due to an innocent error on the part of
the taxpayer or adviser.
d. Regardless of the fact that an innocent misunderstanding was involved, there is no
statute of limitations when a return is not filed.
2. On a Federal income tax return filed five years ago, Andy inadvertently omitted a
large amount of gross income.
a. Andy seeks your advice as to whether the IRS is barred from assessing additional
income tax in the event he is audited. What is your advice?
b. Would your advice differ if you were the person who prepared the return in
question? Explain.
c. Suppose Andy asks you to prepare his current year’s return. Would you do so?
Explain.
Answer:
a. Normally, the three-year statute of limitations applies to additional assessments
the IRS can make. However, if a substantial omission from gross income is made, the
statute of limitations is increased to six years. A substantial omission is defined as
omitting in excess of 25% of the gross income reported on the return.
b. No, it would not. The proper procedure would be to advise Andy to disclose the
omission to The IRS. Absent the client’s consent, do not make the disclosure
yourself.
c. If Andy refuses to make the disclosure and the omission has a material carryover
effect to the current year, you should withdraw from the engagement.
3. Rita files her income tax return 35 days after the due date of the return without
obtaining an extension from the IRS. Along with the return, she remits a check for
$40,000, which is the balance of the tax she owes. Disregarding the interest element,
what are Rita’s penalties for failure to file and for failure to pay?
Answer:
$4,000, determined as follows:
Failure to pay penalty [0.5% × $40,000 × 2 months] $
400
Plus: Failure to file penalty [5% × $40,000 × 2 months] $4,000
Less: Failure to pay penalty for the same period
(400)
3,600
Total penalties: Failure to Pay $400 + Failure to File $3,600 = $4,000.
4. For tax year 2019, the IRS assesses a deficiency against David for $500,000.
Disregarding the interest component, what is David’s penalty if the deficiency is
attributable to:
a. Negligence?
b. Fraud?
Answer:
a. $100,000 (20% × $500,000).
b. $375,000 (75% × $500,000). The answer presumes that civil (not criminal) fraud is
involved.
5. Using the legend provided, classify each of the following statements:
Legend A = Tax avoidance E = Tax evasion N = Neither
a. Sue writes a $707 check for a charitable contribution on December 26, 2021, but
does not mail the check to the charitable organization until January 10, 2022. She
takes a deduction in 2021.
b. Sam decides not to report interest income from a bank because the amount is
only $19.75.
c. Harry pays property taxes on his home in December 2021 rather than waiting
until February 2022.
d. Variet switches her investments from taxable corporate bonds to tax-exempt
municipal bonds.
e. Mel encourages his mother to save most of her Social Security benefits so that
he will be able to claim her as a dependent.
Answer:
a. E.
b. E.
c. A.
d. A.
e. A.
Tax Evasion connotes the use of subterfuge and fraud as a mean to Tax Avoidance.
6. Which of the valuation penalties is likely to arise when an aggressive taxpayer
reports:
a. A charitable contribution?
b. A business deduction?
c. A decedent’s taxable estate?
Answer: The following valuation penalties are likely to apply.
a. Overvaluation. b. Overvaluation. c. Undervaluation.
7. Alexi files her tax return 20 days after the due date. Along with the return, she
remits a check for $3,000, which is the balance of the tax she owes. Disregarding any
interest liabilities, compute Alexi’s total penalties for this period.
Answer:
For failure to file a tax return by the due date (including extensions), a penalty of 5%
per month (up to a maximum of 25%) is imposed on the amount of tax shown as due
on the return, with a minimum penalty amount of $435, but no more than the tax
due. The minimum penalty is waived if the tax is paid within 60 days of the due date
of the return. If the failure to file is attributable to fraud, the penalty rises to 15% per
month, to a maximum of 75% of the tax. For a failure to pay the tax due as shown on
the return, a penalty of 0.5% per month (up to a maximum of 25%) is imposed on the
amount of the tax. The penalty is doubled if the taxpayer fails to pay the tax after
receiving a deficiency assessment. In all of these cases, a fraction of a month counts
as a full month. These penalties relate to the net amount of the tax due.
Failure to pay penalty (0.5% × $3,000) $ 15
Failure to file penalty (5% × $3,000) $150
Less: Failure to pay penalty for the same period (15)
Net failure to file penalty 135
Total penalties $150
8. Rivera underpaid her income tax by $45,000. The IRS can prove that $40,000 of
the underpayment was due to fraud.
a. Determine Rivera’s civil fraud penalty.
b. Rivera pays the penalty five years after committing the fraudulent act. Her
aftertax rate of return on available cash is 9%. What is the present value of Rivera’s
penalty? See text Appendix E.
Answer:
A 75% civil penalty is imposed on any underpayment resulting from fraud by the
taxpayer who has filed a return. For this penalty, the burden of proof is on the IRS to
show by a preponderance of the evidence that the taxpayer had a specific intent to
evade a tax. a. Rivera’s fraud penalty is $30,000 ($40,000 × 75%). b. While beyond
the scope of this class….Present value of the penalty = $19,497 ($30,000 tax payment
deferred × 0.6499 PV table factor).
9. On June 15, 2020, Sheridan filed his 2019 income tax return, paying a tax of
$10,500. On October 5, 2021, he filed an amended 2019 return showing an
additional $6,400 of tax, which he paid with the amended return. On August 22,
2023, he filed a claim for a refund of $7,000. How much Federal income tax can
Sheridan recover on the amended return?
Answer:
Typically, a refund claim must be filed within three years of the filing of the tax return
or within two years following the payment of the tax if this period expires on a later
date. Assuming that the tax law supports Sheridan’s refund, he can recover only
$6,400. Because the claim was not filed within the three-year statute of limitations
period, Sheridan is limited to the amount he actually paid during the last two years.
10. Rita forgot to pay her Federal income tax on time. When she actually filed, she
reported a balance due. Compute Rita’s failure to file penalty in each of the
following cases.
a. Two months late, $1,000 additional tax due.
b. Five months late, $3,000 additional tax due.
c. Eight months late, $4,000 additional tax due.
d. Two and a half months late, $3,000 additional tax due.
e. Five months late due to fraud by Rita, $4,000 additional tax due.
f. Ten months late due to fraud by Rita, $15,000 additional tax due.
Answer: The failure to file penalty is 5% per month of the tax due, with a $435
minimum penalty and a maximum penalty of 25%. In the case of fraud, the penalty
rate is tripled.
a. 5% × 2 months × $1,000 tax due = $100, but apply the larger $435 minimum
penalty.
b. 5% × 5 months × $3,000 tax due = $750 penalty.
c. 5% × 5 months maximum × $4,000 tax due = $1,000 penalty.
d. A partial month counts as a full month. Penalty = 5% × 3 months × $3,000 tax due
= $450.
e. 15% × 5 months × $4,000 tax due = $3,000 penalty.
f. 15% × 10 months × $15,000 tax due = $22,500, but limited to 75% of the tax due =
$11,250.
11. Linn filed her 2020 Form 1040 on April 4, 2021. What is the date on which the
applicable statute of limitations expires in each of the following independent
situations?
a. Linn incurred a bad debt loss that she failed to claim.
b. Linn inadvertently omitted one-third of the correct gross income.
c. Same as part (b), except that the omission was deliberate.
d. Linn innocently overstated her deductions by a large amount.
e. No return was filed by Linn.
Answer:
a. April 15, 2028. Although claims for refund normally are limited by the three-year
rule, seven years applies in the case of bad debts and worthless securities.
b. April 15, 2027. For a substantial omission (i.e., more than 25%) of gross income, a
six-year statute of limitations comes into play.
c. If the omission was deliberate, fraud probably is involved. There is no statute of
limitations on fraud.
d. April 15, 2024. The normal three-year statute applies. Unlike the substantial
omission of income situation, the six-year statute does not materialize for
overstatement of deductions.
e. The statute of limitation never expires.
12. Loraine (a calendar year taxpayer) reported the following transactions, all of
which were properly included in a timely filed return.
Gross receipts $975,000
Cost of sales (850,000)
Gross profit $125,000
Capital gain $40,000
Capital loss (25,000) 15,000
Total income $140,000
a. Presuming the absence of fraud, how much of an omission from gross income
would trigger the six-year statute of limitations?
b. Would it matter if cost of sales had been inadvertently overstated by $150,000?
c. How does the situation change in the context of fraud by Loraine?
Answer:
a. Loraine must omit an amount of gross income that is in excess of 25% of the gross
income
stated on the return for the six-year statute of limitations to apply. Here, the
omission must exceed $253,750 [($975,000 + $40,000) × 25%]. When gross income
for the period includes capital gains, such capital gains are not reduced by capital
losses.
b. No. This extended period of limitations rule has been interpreted to include only
the omission of items affecting income, not the omission of items affecting cost of
sales.
c. There is no statute of limitations in the context of tax fraud.. The statute never
expires. The absence of a return precludes the running of the statute of limitations.