In this third installment of “In Practice,” we distill research published in tax and accounting journals that should be of interest to busy tax practitioners. The pervasiveness of tax considerations in the affairs of everyone from students to CEOs makes the field a particularly fertile one for studying financial behavior. Authors of the following research have derived findings that carry implications for tax practitioners and those using professional tax services. Their work has been published in Accounting Horizons, Contemporary Accounting Research, Journal of the American Taxation Association, The ATA Journal of Legal Tax Research and the National Tax Journal.
AGGRESSIVE TAX POSITIONS AND THE EXPECTATIONS GAP
Professional tax preparers perform services for their clients that are generally more aggressive than their clients prefer, according to research. Studies of “client advocacy” measure the expectations of service from the tax professionals’ and the taxpayers’ perspectives. Research shows that while tax preparers assume their clients prefer more aggressive positions, clients actually prefer reduced risk. Prior research was conducted with large firms, although more than half of all returns are prepared by self-employed, local or regional firms, including non-CPAs and nonenrolled preparers.
Author Teresa Stephenson’s research surveyed more than 500 tax preparers in 2005 to determine the difference between tax preparers’ perspective of what their clients wanted and the clients’ actual expectations. The sample consisted of non-Big Four firms and included small CPA firms and non-CPAs. The December 2007 article published in Accounting Horizons (“Do Clients Share Preparers’ Self-Assessment of the Extent to Which They Advocate for Their Clients?”) supports prior research in this area showing taxpayers prefer less-aggressive preparers. The author’s survey reveals the misperceptions between preparer and taxpayer. This discrepancy is found regardless of whether a CPA or non-CPA prepares the return.
The research provides a further understanding of the miscommunications between professional tax preparers and their clients. Stephenson’s study suggests that clients not only misunderstand their tax preparer’s intentions but that taxpayers generally prefer a more conservative approach than that perceived by preparers. In light of these findings, tax preparers and advisers may want to review their communication procedures, particularly how they discuss with their clients matters of risk preferences and tolerance.
SHOULD OLDER EMPLOYEES CONTINUE WORKING OR RETIRE?
As the baby boomers reach retirement age, concerns over the adequacy of Social Security, health care and other benefits have led policymakers to consider incentives to encourage workers to remain in the work force. Prior research shows employees will choose retirement if they believe they will lose benefits by remaining employed. However, delayed retirement enhances not only employees’ current income and benefits in areas such as health care and future Social Security but also adds to economic productivity in the U.S. This in turn increases income tax and Social Security revenue.
Barbara Butrica, Richard Johnson, Karen Smith and Eugene Steuerle analyzed the combined impact of factors that encourage retirement—and discourage working—by calculating an “implicit tax rate” on workers who remain employed after age 55. Costs of staying in the work force include income tax and Social Security withholdings, lost benefits, reduced Social Security and Medicare benefits, and the deferral of pension benefits.
The authors measured the implicit tax rate associated with an additional year of employment at various ages, marital statuses and life expectancies. Results reveal an increasing implicit tax rate as workers age, ranging from approximately 14% at age 55 to 50% at age 70.
The research, published in the June 2006 National Tax Journal, is titled “The Implicit Tax on Work at Older Ages.” The study suggests that tax policy that encourages work and discourages retirement will increase economic productivity, generate additional tax revenue and reduce the increasing tax burden created by an aging population.
BIGGER REFUNDS CORRELATE WITH HIGHER PREPARATION FEES
Authors Scott Jackson, Paul Shoemaker, John Barrick and Greg Burton studied the relationship between tax return preparation fees and taxpayers’ prepayment position on their completed return of either a refund or an amount due. Prior research shows that despite the interest-free loan received by the government due to overpayment of estimates, taxpayers prefer a refund. This occurs whether the tax return is prepared by a professional or not. Furthermore, evidence shows that refunds have increased in recent years.
The current research, building on prior studies, analyzed taxpayers’ motivation to overpay beyond the safe harbor amounts, particularly when returns are professionally prepared. Their work, drawing on “mental accounting theory,” examines taxpayers’ “favorable mental representation” of tax preparation fees when taxpayers are in a refund position, which in turn is shown to allow tax preparers to charge and collect more of their billable time.
The authors analyzed IRS data for more than 68,000 taxpayers to test their theory. Their findings, supported by strong statistical analysis, indicate a very clear relationship between tax preparation fees and taxpayers who receive refunds, versus taxpayers with a balance due on their return. The relationship holds true for tax preparation fees that are greater or less than the taxpayer’s refund. The study found that large taxpayer refunds generally result in a proportionally larger tax preparation fee. Conversely, proportionally lower fees occur with lower tax refunds or amounts due.
The authors note that their research cannot determine the intent or perceptions of either the taxpayer or tax preparer. Nonetheless, it suggests overpayment of estimated tax might not be detrimental to client satisfaction and may in many cases increase it. The work, titled “Taxpayers’ Prepayment Positions and Tax Return Preparation Fees,” appeared in the Summer 2005 issue of Contemporary Accounting Research.
PRACTITIONERS’ MORAL MAJORITY
Tax professionals face unique ethical challenges in their role as both an advocate for the client and in their responsibility for compliance with the law. This dual role emphasizes the need for a strong ethical environment within the firm. This can best be achieved through in-house ethics training and a performance evaluation process that offers incentives for ethical behavior and penalizes lapses, according to “An Experiential Investigation of Tax Professionals’ Ethical Environments.” Authors Donna Bobek and Robin Radtke studied the tax professionals’ ethical environment, analyzing the relationship between practitioners’ view of their firms’ ethical environment and the ethical dilemmas encountered in practice.
Ratings of ethical environments were very strong overall, and participants in the survey indicated an enhanced focus on firm ethics in recent years. Eighty-six of the 146 survey participants stated they had faced a specific ethical dilemma at their firms. These participants faced ethical issues involving client pressure, client retention, time constraints, difficulty determining the accuracy of certain client information, and a perception that the client had acted in an unethical manner. Factors contributing to the resolution of these ethical dilemmas were described as professional experience, communication and personal ethical beliefs, although internal firm training was shown to assist as well.
The relationship between ethical dilemmas and the professionals’ perception of their ethical environment reveals the importance of an effective firm culture focused on appropriate social norms, awareness and training. Persons rating their firms’ ethical environment as strong typically described encountering fewer ethical dilemmas. Persons who rated their environment as strong and who had faced an ethical dilemma perceived their situation as more serious than those who had faced an ethical dilemma but rated their firm’s ethical environment lower. This suggests an enhanced awareness is created by firms with a strong ethical environment. Researchers suggest that individuals in firms with a strong ethical environment are also better equipped with tools for improved resolution of problems.
The research, appearing in the Fall 2007 Journal of the American Taxation Association, reinforces the argument that inhouse ethics training and an enforceable ethics code, as well as the reinforcement of “strong social norms” for the individual, co-worker and management, encourage a stronger ethical environment.
IS UNRELATED BUSINESS INCOME UNDERREPORTED?
Nonprofits are subject to the unrelated business income tax (UBIT) on income earned from business activities that are unrelated to a nonprofit’s tax-exempt purpose. The UBIT’s primary purpose is not to raise revenues, but rather to make sure nonprofits don’t have an unfair competitive advantage over a taxable entity. Prior research suggests that nonprofits try to reduce their UBIT liability by shifting expenses from their tax-exempt activities to their taxable activities. Shifting expenses would increase nontaxable income and decrease taxable income.
In general, the tax laws governing expense allocation methods for nonprofits are relatively broad, with the primary requirement that the method be reasonable and consistently applied. For some taxable activities, however, compliance rules mechanically limit the amount of expenses that can be reported. Expense amounts exceeding this limit would indicate that a nonprofit overstated its expenses and thus incorrectly understated taxable income.
Authors Thomas Omer and Robert Yetman used a confidential set of nonprofit tax returns (Form 990-T) to determine whether nonprofits in the sample misreported their expenses and, if so, by how much. The authors found that 19% of the nonprofits in the sample reported more expenses on their Form 990-T than was allowed under existing tax law, and the average overstatement was 30% of reported expenses. Although the authors documented that nonprofits misreport expenses, they were unable to determine whether this misreporting was intentional (tax evasion) or unintentional (random errors).
The authors examined the factors that affect nonprofits’ misreporting of expenses. They found that nonprofits are more likely to misreport expenses when tax rates are higher, when a nonprofit’s tax return is more complex, and when a nonprofit’s taxable and tax-exempt activities are more likely to share common expenses. The authors also found that misreporting is lower when a nonprofit faces increased reporting to state agencies. Additional reporting requirements increase the probability that errors will be detected, making it less likely that nonprofits will misreport. The magnitude of this study’s results suggests that relatively modest changes in tax rates and reporting requirements, plus accounting system flexibility, can have large effects on nonprofits’ tax avoidance behavior. The study, titled “Tax Misreporting and Avoidance by Nonprofit Organizations,” was published in the Spring 2007 issue of the Journal of the American Taxation Association.
PERSONAL USE OF CORPORATE AIRCRAFT EXAMINED
Personal use of company-owned aircraft by company executives increased significantly in the past decade. This resulted in increased congressional and IRS scrutiny of the tax treatment of these activities. A paper by Karen Miller, Riley Shaw and Tonya Flesher (“Taxation of Personal Use of Corporate Aircraft: Should Income Equal the Deduction?”) tracked changes in the tax law regarding the personal use of corporate aircraft. The authors addressed three questions: What amount should be included as compensation by the employee for the personal use of the company’s aircraft? How much should the employer deduct for the operating cost related to the personal use? Should these amounts be equal?
The American Jobs Creation Act of 2004 (AJCA) substantially changed the tax treatment of the costs associated with the personal use of corporate-owned aircraft. The authors began by discussing the legislative and judicial history that preceded these changes. Prior to the AJCA, court decisions allowed companies to deduct the full operating costs incurred to operate business aircraft if the employee reported the value of personal use as compensation. Compensation was generally calculated using the Standard Industry Fare Level (SIFL) rates, which could result in income amounts that were substantially less than the corporation’s deductions. The AJCA’s provisions disallow deducting the costs of personal use of business aircraft by “specified individuals” to the extent these costs exceed the corresponding compensation amount. Specified individuals include officers, directors, and greater than 10% owners of a corporation. However, the tax treatment for non-specified individuals did not change, potentially resulting in inequitable tax treatment.
Congress continues to debate the deductibility of personal use of company aircraft, and the authors focused on several recent legislative proposals. One of these provisions would require employees to recognize income based on the actual cost of using the aircraft, and companies would be allowed a full deduction for the actual cost. The authors argued that this treatment taxes the transaction more consistently with its economic reality and increases fairness. Under current law, private citizens incur taxes on all their income used to purchase personal flights, while executives using corporate aircraft only incur taxes on a portion of the actual costs of their flights. Taxing executives on actual cost more nearly treats them as private citizens. This type of proposal might discourage the personal use of corporate aircraft, which would benefit company shareholders by decreasing their subsidy of executives’ personal travel. This paper appeared in The ATA Journal of Legal Tax Research (October 2007).
KNOWING MORE ABOUT NOLs
Corporate income tax systems treat losses differently than income. While positive taxable income is immediately taxable, net losses must be carried back to receive an immediate refund of taxes paid in prior years, or carried forward to offset future tax payments. Carrying a loss forward can decrease the loss’s real value because the tax benefits are not realized until a future date. In the extreme case, a loss will have no value if it is carried forward but never used.
Corporate tax losses are widespread. For tax years 1993 through 2003, approximately 2.1 million companies filed a corporate income tax return each year. Between 43% and 51% of firms reported a loss, and the average reported loss ranged from $100,000 to $400,000. Most companies could not use their full loss as a carryback.
To better understand how quickly corporations are able to use tax losses, authors Michael Cooper and Matthew Knittel examined a large sample of corporate tax returns for the period. Both authors are members of the Office of Tax Analysis, Department of Treasury, with access to tax return data. The sample included approximately 46,000 to 68,000 companies each year. Loss companies constituted 30% to 40% of the sample, with the average loss ranging from $5 million to $14 million.
For most tax years, the authors found that approximately 10% to 15% of losses are carried back for an immediate refund. About 40% to 50% of losses were used as a carryforward deduction within 10 years of the initial loss year, but in many cases only after a substantial delay. An additional 10% to 20% of losses remained unused at the end of the 10-year carryforward period the authors examined, and approximately 25% to 30% of NOLs were never used.
Large amounts of NOLs were generated in recent years (2000 to 2003) and remained unused as of 2003. These loss companies were generally members of industries that are cyclical, overinvested or characterized by high fixed costs. Even if these corporations become profitable again, the authors believe it will be many years before these companies can generate sufficient taxable income to use such large NOL carryforward amounts. Differences in NOL usage can help explain why certain industries respond less to tax incentives, such as accelerated depreciation. Understanding NOL usage is especially important as policymakers consider ways to stimulate economic growth.
This study, “Partial Loss Refundability: How Are Corporate Tax Losses Used?” appeared in the September 2006 issue of the National Tax Journal.
THE EFFECT OF FIN 48 ON TAX RESERVES
FASB Interpretation no. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, is intended to standardize accounting for uncertain tax positions by providing recognition and measurement rules and, where applicable, by requiring companies to disclose the amounts of their tax reserves. The reserve represents the firm’s estimate of additional tax expense the firm expects to owe if the position is challenged by the taxing authorities and after all litigation is resolved.
How will FIN 48 affect the tax reserve amounts reported on companies’ financial statements? Are businesses adjusting their reserve amounts prior to adopting FIN 48? To help answer these questions, authors Jennifer Blouin, Cristi Gleason, Lillian Mills and Stephanie Sikes summarized tax-related financial statement disclosures before and after adoption of FIN 48. Their sample consisted of the 100 largest and the 100 smallest nonregulated and nonfinancial public companies with a calendar year-end, covered by at least five analysts on the Institutional Brokers Estimate System.
The authors argued that companies have incentives to reduce their reserve amounts prior to adopting FIN 48. Large tax reserves could be used by the IRS as a signal of tax aggressiveness, thereby increasing the chances of audit. The authors anticipated that large companies were more likely than small ones to reduce tax reserves in the years preceding FIN 48. This is because large enterprises are subject to continual audit by the IRS and are more likely than small ones to have excess reserves.
As expected, the authors found that decreases in reserves prior to FIN 48 were more frequent for large companies compared with small ones. For the largest 100 companies, the authors found that decreases in reserves were more frequent in 2006 than in 2005 but were not larger in amount. For small companies, there was no difference between 2005 and 2006 in the frequency or amount of changes in reserve amounts.
For the largest 100 companies, the unrecognized tax benefit on Jan. 1, 2007, (the adoption date of FIN 48) was $78 billion, excluding accrued interest and penalties. This equaled approximately 2% of total company assets. There were significant differences across enterprises in the size of their reserves. Several businesses’ reserves exceeded $5 billion and in some cases exceeded 5% of total assets.
Of the $78 billion, companies disclosed that $58 billion would increase earnings if the uncertainty were resolved in the taxpayer’s favor. The $20 billion difference is likely related to temporary differences or valuation issues related to mergers and acquisitions. These amounts would result in balance sheet reclassifications or equity adjustments. Accrued interest and penalties were potentially about $13 billion.
Disclosures for the 100 small companies told a very different story. Only five of the 100 small companies decreased reserves upon adopting FIN 48. Small companies were more likely to increase reserves (39 companies) or not change reserves (56 companies).
Of importance to both financial accounting and tax practitioners, the authors found inconsistencies across companies’ FIN 48 financial disclosures. For example, it is often unclear whether the gross reserve for unrecognized tax benefits includes or excludes accrued interest payable. It is also unclear whether the disclosure of the reserve amount that would affect earnings includes or excludes interest expense. Although the authors remain optimistic that future disclosures will increase in clarity and comparability, they note that guidance on best practices would help clarify and improve FIN 48 reporting. FASB, the SEC, the Big Four and other auditing firms can all play an important role in providing guidance. This study, titled “What Can We Learn About Uncertain Tax Benefits From FIN 48?” was published in the September 2007 issue of the National Tax Journal.
The full text of each article describes these studies in detail for those interested in specifics related to the research process.
Cynthia Bolt-Lee, CPA, M. Taxation, is an associate professor at The Citadel School of Business Administration in Charleston, S.C. Elizabeth Plummer, CPA, Ph.D., is an associate professor of accounting at the Neeley School of Business at Texas Christian University in Fort Worth, Texas. Their e-mail addresses, respectively, are email@example.com and firstname.lastname@example.org.