On June 15, 2013,
Marianne Wise and Dory Holland came to your office for an initial meeting. The primary purpose of the meeting was to
discuss Wise-Holland Corporation’s tax situation. Marianne and Dory each own 50% of
Wise-Holland Corporation, an S corporation.
Dory and her husband Phil will continue to use another tax accountant for
their on-going personal tax work, but Marianne wants to engage your services
for her personal tax return. Marianne is
Wise-Holland is a calendar year corporation established
in Naples, Florida on January 1, 2001.
The corporation’s principal business is locating and selling unique
interior design items. Marianne and Dory
have been friends since college, where they were both art majors. After graduation, they each held various
positions where they gained experience in interior design before joining
together to start this business. They
are pleased but stunned by the financial success of their business, because the
initial business plan was crafted simply to focus on what they liked to do and
have more flexible schedules than they had as employees of others. They feel very dependent on their accountants
and other financial advisers, because they have no experience or training in
Marianne is unhappy with the tax accountant (Amanda
Klinger) who prepared her individual tax return and has advised her on tax
issues for the past ten years.
Specifically, Marianne is dissatisfied because she had received a notice
of deficiency from the IRS disallowing deductions on her 2009 tax return. The disallowance related to an investment that
Marianne had made in that year in the Lucky Partnership, a venture that
operates medical clinics throughout the state.
Lucky was a small partnership and not subject to the unified audit and
litigation procedures. Because Lucky also
was under audit, Marianne signed a waiver extending the statute of limitations
for her 2009 individual return for three more years. Now, she and Dory just received an audit
notice for Wise-Holland’s 2008 S corporation tax return.
You have never prepared or reviewed Marianne’s
individual return or Wise-Holland’s corporate return. After your initial meeting with Marianne and
Dory, you gathered all essential information to begin your engagement. You have obtained the following documents.
Marianne’s individual tax returns for tax years 2007 through 2011. These returns were timely extended and filed
on October 15 of the appropriate year.
Marianne’s filing status was Single for all of these returns. Her annual taxable income during these years
was approximately $150,000 – $200,000.
S corporation tax returns for tax years 2007 through 2012. These returns were timely filed on March 15
of the appropriate year.
An installment note for the sale of land, building, and equipment by
Marianne in 2010.
A notice of tax deficiency from the IRS for Marianne’s 2009 tax return.
An audit notice dated June 1, 2013, for Wise-Holland’s 2008 tax return.
Various information and financial records necessary to compute 2012
taxable income for Marianne Wise.
A review of these documents and discussions with
Marianne and Dory provided the following additional information. None of the taxpayers has engaged in a tax
shelter or other reportable transaction.
Notice of Deficiency â Marianneâs 2009 tax return
The deficiency notice for the 2009 return shows $20,000 federal
income tax due resulting from the disallowance of loss flow-throughs from Lucky. The stated reason for the disallowance was
that there was no profit motive supporting the partnership. In addition to the tax deficiency, the notice
reflects interest and a 20 percent penalty for substantial understatement of
Marianne relied on Amanda Klinger to make a good faith
effort to evaluate the legitimacy of the losses from Lucky; Marianne was not
negligent in claiming the Lucky losses on her individual return. Marianne is perturbed because Amanda assured
her that the tax return positions were reasonable and there was little risk the
IRS would disallow the deductions.
Marianne also disagrees with the penalty because she
maintains that she did not intentionally understate her tax liability. When she discussed the penalty with Amanda in
January 2013, Amanda told her to pay the tax deficiency, including the interest
and penalties, as there was no defense available for her benefit. Marianne and Phil immediately made that
payment. The IRS disallowance affects only
the 2009 tax year.
Sale â 2010
In early 2010, Marianne sold land, building, and
equipment for $300,000 to an unrelated third party, June Lockmann. Marianne received an installment note payable
at the rate of $60,000 per year for five years,i.e. payments would be received from 2010 through 2014. The installment sale was reported in
Marianne’s 2010 tax return. The basis of
the property was $150,000. The total gain and character of the gain is as
Marianne brought a $75,000 capital loss carryover into 2010. Therefore, Amanda decided to prepare
Marianne’s returns reporting $30,000 of Â§1231 gain in 2010 and $20,000 in 2011,
to utilize the capital loss carryover as quickly as possible. Amanda reported the transaction in this way.
RETURNS AS FILED–EFFECT ON GROSS INCOME
/ 5 tax years
Effect on Gross Income
Audit Notice â Wise-Hollandâs 2008
The audit notice for Wise-Holland questions certain
deductions claimed on the return on the basis that they are nondeductible
personal items. Based on your review of
the detail and discussions with Marianne and Dory, you conclude that certain
deductions for materials and supplies should have been characterized as
personal expenditures and are not deductible by the S corporation.
When Wise-Holland’s return originally was prepared,
Marianne and Dory believed that these deductions were valid business
expenditures, and they made a good-faith effort to segregate their personal
expenditures from their business expenditures.
You do not believe the IRS can make any adjustment at this time, because
it has been more than three years since Wise-Holland filed its 2008 tax return.
Ambiguous Tax Issue â Wise-Hollandâs 2011
In your review, you identified an expense in the
financial statement that presents an ambiguous tax issue for the S
corporation’s 2011 tax return â the corporation deducted an item that might be
interpreted as being capitalizable. The
amount of tax relating to this issue is approximately $10,000, and you estimate
that it will exceed 10% of the total tax liabilities for Marianne and Dory for the
In reviewing the relevant facts and law, you found six
trial court cases that support the IRS position (to capitalize). One old District Court decision in Florida
supports the taxpayer’s position (to deduct in full in the current year). The only appellate court decision (10th
Circuit) supports the IRS position (reversing a Tax Court decision). The Wise-Holland expenditure is quite similar
to those discussed in the court cases, although none of the court cases
represent a fact pattern identical to Wise-Hollandâs.In your view, there is a meaningful
distinction between the Wise-Holland expenditure and that presented in the 10th
You have assessed that Wise-Holland’s chances of
prevailing on the issue would be very small if the matter were litigated. After you explained your preliminary
evaluation of the weakness of their position, Marianne and Dory stated that
they want you to prepare the return taking the immediate deduction, which will
require disclosing the position on the return.
Your discussion with them included only an analysis of the tax issue,
and not other matters like the low probability of the return being audited by
In considering whether to take on Wise-Holland and
Marianne Wise as tax clients, you have done some research that indicates that
in certain circumstances, the preparer of a passthrough entity’s tax return and
Schedules K-1 can be deemed to be the preparer of an individual’s Form 1040 on
which the data from the passthrough entity’s return was entered. Tax
return preparer includes any person who prepares a substantial portion of a
return for compensation..doc#_ftn1″> Whether a schedule, entry, or other portion
of a return is asubstantial portion
is determined by:
whether the preparer
knew or should have known that the resulting tax result is a substantial
portion of the tax to be shown on the return.
the size and
complexity of the item relative to the taxpayerâs gross income.
the size of the
attributable understatement relative to the taxpayerâs reported tax liability..doc#_ftn2″>
The question then is whether the K-1 numbers constitute
a “substantial portion” of the return.
Today it is September 1, 2013. You hold a valid CPA license in your state,
and you are classified by the IRS as a tax return preparer.
REQUIRED: Determine your general responsibilities concerning
all of these matters, as a CPA under the AICPA’s Statements on Standards for
Tax Services (.aicpa.org/InterestAreas/Tax/Resources/StandardsEthics/StatementsonStandardsforTaxServices/DownloadableDocuments/SSTS,%20Effective%20January%201,%202010.pdf”>SSTSs, latest version effective 2010) and under Treasury
Department.irs.gov/pub/irs-pdf/pcir230.pdf”>Circular 230. Prepare a chart,
table, or graphic summarizing taxpayer and tax practitioner reporting
standards. Also evaluate the potential
penalties applicable to practitioners and taxpayers under the Internal Revenue
REQUIRED: Identify all procedural and reporting issues
that exist in the Wise-Holland facts. In
particular, you should address the following issues.
statutes of limitations
REQUIRED: Evaluate the first three
issues (Notice of Deficiency, Installment Sale, and Audit Notice) from the
perspective of the taxpayer, taking into account the pertinent tax practitioner
responsibilities and penalties.
REQUIRED: For the
deduct-or-capitalize issue, analyze the conclusions that a CPA must draw in
deciding how to advise a client regarding an ambiguous tax position, and in
determining whether he or she can sign a tax return and comply with statutory
standards, the SSTSs, and Circular 230.
Analyze all possible results, from a conclusion that a position has substantial
authority to a conclusion that a position is frivolous.
Preparer penalties that are
pertinent here are found in Â§6694, taxpayer penalties start with Â§6662. They
are similar but not identical to the rules of .irs.gov/pub/irs-pdf/pcir230.pdf”>Circular 230,
nor to the AICPAâs .aicpa.org/InterestAreas/Tax/Resources/StandardsEthics/StatementsonStandardsforTaxServices/DownloadableDocuments/SSTS,%20Effective%20January%201,%202010.pdf”>SSTSs.
Special sanctions relate to the filing of frivolous returns.
Taxpayer and tax preparer penalties
under the Code are not always identical.
Can a taxpayer avoid an
understatement penalty because of reliance on the advice of a tax professional?
When do interest payments begin to
accumulate? Can the IRS waive penalties? Interest liabilities?
When a tax understatement is
discovered, is the CPA obligated to inform the client? The IRS?
Was there an error on Marianneâs
return concerning the installment sale? What are the proper responses to the
discovery of an error on a tax return?
Recompute the 2010 â 2012 taxable
income amounts regarding the installment note, by correcting the error. What
now is Marianneâs capital loss carryover into 2013?
Does the audit notice fall within
the statute of limitations period?
Review the use of Form 8275
in dealing with an ambiguous tax filing position.