Risk Assessment & Mitigation Flashcards

A client operates a cash-intensive business with inconsistent recordkeeping. Which IRS audit technique does this most directly invite?

Answer: Bank deposit analysis to reconstruct unreported income

The IRS uses bank deposit analysis to reconstruct income when records are poor, making cash-intensive businesses with weak recordkeeping prime candidates for this technique.

Which strategy best mitigates the risk of a client's S corporation losing its tax status due to an inadvertent invalid election?

Answer: Continuously monitoring shareholder eligibility requirements throughout the year

S corporation status is lost if ineligible shareholders (e.g., nonresident aliens or corporations) acquire shares, so continuous monitoring of shareholder eligibility is the primary mitigation control.

A taxpayer claims a home office deduction for a room also used regularly for personal activities. What is the primary tax risk?

Answer: Disallowance of the deduction due to failure to meet the exclusive-use test

IRC §280A requires that the home office space be used exclusively and regularly for business; any personal use disqualifies the entire deduction.

When assessing tax risk for a client who received a large legal settlement, which classification determination is most critical?

Answer: Whether the proceeds are compensatory for physical injury or punitive damages

Under IRC §104, proceeds compensating for physical personal injury are excludable from gross income, while punitive damages are fully taxable regardless of the underlying claim.

A tax practitioner discovers a material error on a prior-year return that resulted in underpayment. Under Circular 230, what is the practitioner's primary obligation?

Answer: Promptly advise the client of the error and its potential consequences

Circular 230 §10.21 requires practitioners to promptly advise clients of errors or omissions on prior returns and recommend corrective action, but it does not require the practitioner to notify the IRS directly.

Which factor most significantly increases the risk of penalties under IRC §6662 for a substantial understatement of income tax?

Answer: Taking an undisclosed tax position that lacks substantial authority

The §6662 substantial understatement penalty is reduced or avoided when a position is disclosed and has a reasonable basis, but undisclosed positions require substantial authority (roughly 40% likelihood) to avoid the penalty.

A client transferred appreciated property to a family partnership and immediately received a cash distribution. What tax risk does this transaction present?

Answer: Step transaction doctrine treating the contribution and distribution as a taxable disguised sale

The IRS may apply the step transaction doctrine to collapse the contribution and distribution into a disguised sale under IRC §707(a)(2)(B), making the transaction immediately taxable.