CTC Risk Assessment & Mitigation 2 — Questions and Answers
Question 1: A client operates a cash-intensive business with inconsistent recordkeeping. Which IRS audit technique does this most directly invite?
- High itemized deductions relative to income
- Bank deposit analysis to reconstruct unreported income (Correct answer)
- Excessive business meal deduction scrutiny
- Mismatch between W-2 and Schedule C income
Correct 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.
Question 2: Which strategy best mitigates the risk of a client's S corporation losing its tax status due to an inadvertent invalid election?
- Filing Form 2553 annually to reaffirm the election
- Continuously monitoring shareholder eligibility requirements throughout the year (Correct answer)
- Electing C corporation status as a backup
- Limiting distributions to equal shares only
Correct 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.
Question 3: A taxpayer claims a home office deduction for a room also used regularly for personal activities. What is the primary tax risk?
- Disallowance of the deduction due to failure to meet the exclusive-use test (Correct answer)
- Increased self-employment tax liability
- Recapture of depreciation at ordinary income rates upon sale
- Loss of the principal residence exclusion on sale
Correct 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.
Question 4: When assessing tax risk for a client who received a large legal settlement, which classification determination is most critical?
- Whether the settlement was paid in installments or lump sum
- Whether the proceeds are compensatory for physical injury or punitive damages (Correct answer)
- Whether the defendant was an individual or a corporation
- Whether attorney fees were paid on a contingency basis
Correct 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.
Question 5: 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?
- Immediately notify the IRS of the error without client consent
- Promptly advise the client of the error and its potential consequences (Correct answer)
- Amend the return without informing the client to limit exposure
- Do nothing unless the statute of limitations has not expired
Correct 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.
Question 6: Which factor most significantly increases the risk of penalties under IRC §6662 for a substantial understatement of income tax?
- Filing the return on extension
- Taking an undisclosed tax position that lacks substantial authority (Correct answer)
- Using a paid tax preparer rather than self-preparing the return
- Electing out of bonus depreciation
Correct 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.
Question 7: A client transferred appreciated property to a family partnership and immediately received a cash distribution. What tax risk does this transaction present?
- Step transaction doctrine treating the contribution and distribution as a taxable disguised sale (Correct answer)
- Failure to file Form 1065 for the partnership
- Disallowance of the partnership's depreciation deductions
- Loss of the annual gift tax exclusion for the transfer
Correct 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.
CTC Risk Assessment & Mitigation 2
A client operates a cash-intensive business with inconsistent recordkeeping.
Which IRS audit technique does this most directly invite?