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Jan 1994

Tax expert systems and future development. (The CPA & the Computer)

by Porter, Eugene P.

    Abstract- Expert systems specially developed for auditing and taxation purposes have become an integral part of the accounting profession's decision making armory. They are now widely used to tackle such diverse problems as the evaluation of internal controls, the determination of materiality limits, and the organization of accounts receivables collections. Early expert systems developed in the late 1970s, such as Taxman I and II, tended to be fairly simple, having been designed for the automated analysis of simple corporate tax cases. More advanced expert sysems developed in the 1980s, such as Taxadvisor, Investor and Financial Advisor, were designed to solve more complex problems and became fairly popular among practitioners. Current expert systems, such as Expertax, are capable of highly complex tasks and are typically designed to tackle very specialized tax and auditing issues.

Expert System Components

There are four component parts to an expert system; the knowledge base, the inference engine, the user interface, and other interfaces. The knowledge base contains the facts about a specific task and rules for applying the facts.

The inference engine enables the expert system to access the knowledge stored in the knowledge base and drives the system as it draws an inference by relating user supplied facts to knowledge base rules. In this manner, the system reaches a conclusion concerning the problem it is solving.

The user interface provides communication between the inference engine and the system user. Other interfaces may include an explanation facility that explains why the expert system has asked a specific question or reached a particular conclusion

Tax Expert System Examples

As a result of previous research, several tax expert systems have been developed. Some of these systems are described below.

In 1977, Taxman I was developed to test the consequences of certain corporate reorganization transactions. This expert system was able to represent a complete set of facts in a corporate tax case and also was able to represent the full set of statutory rules and concepts which classified such cases. In 1979, Taxman II was developed to solve problems involving legal concepts and to produce human like patterns of cognitive theory for information processing of arguments.

In 1982, the expert system, Taxadvisor was developed to solve problems dealing with income and transfer tax planning for individuals. The system was designed to make recommendations, based upon projected future events, for tax-related actions which would maximize the wealth that an individual transferred at death.

In 1987, Investor was constructed, which assisted in the selection of real estate or oil and gas tax shelters. The system recommended the first acceptable choice for an individual, which was not always the best choice.

Financial Advisor, an expert system developed in 1985, was the first commercially successful system to be used by tax consultants. The system provided advice on projects, products, mergers, and acquisitions. Information was provided about a company, .red the system evaluated proposed transactions, changes in the tax law, or other problems.

Perhaps the most successful tax expert system is Expertax. Coopers and Lybrand developed the system, which supports the corporate tax accrual and planning process. The system gives advice and guidance to auditors and tax specialists in preparing the tax accruals for financial statements. It also identifies important issues for tax planning, tax compliance, and tax services.

New Type of Expert System

In 1987 the AICPA published a special management advisory service report, An Introduction to Artificial Intelligence and Expert Systems. The objective of the report was to present information about expert systems including their basic components, opportunities for the accounting profession, and prospects for the future.

One section of the report discussed specific applications in the accounting area suitable for future expert system development such as proper accounting treatment for complex transactions associated with leases, foreign exchange, acquisitions, pensions, and income taxes.

The expert systems suggested in the AICPA report represent a departure from traditional accounting expert systems, which require a human expert to provide knowledge and experience for inclusion in the system's knowledge base. The content of the knowledge base of this new type of expert system will be the accounting literature that defines GAAP in a complex accounting area or the appropriate IRC section that prescribes the proper tax treatment for a specific tax issue. The human expert's value will be in the validation of the expert system.

Two examples of such expert accounting systems are--

* A lease expert system constructed by Boer and Livnat that identified the proper accounting treatment for leases by the lessee.

* A business combination expert system developed by McDuffie that reviews a combination and defines it as either a purchase or as a pooling of interests.

Similar type tax expert systems can be constructed as well, which can be categorized into two groups.

Compliance Supplementation

The inherent limitations of tax expert systems for compliance-type work are two-fold: 1) the enormous number of potential transactions that can affect a taxpayer and 2) the frequency of law changes. Therefore, tax- expert-system development for compliance-type work should be constructed into separate specialized systems or modules. These modules would have potential application in the determination of the tax treatment of a particular transaction or area of the law. Several examples are discussed below.

Oil, Gas, or Geothermal Well Drilling Expenses. Intangible drilling and development cost may be either currently deductible or capitalized and the cost recovered through depletion or depreciation.

A tax expert system in this area would be effective in determining the optimum tax treatment for IDCs, considering limitations, tax rates, the amortization period, and the consequences of a current deduction constituting a tax preference item for alternative minimum tax purposes.

Computation of Investment Interest Deduction. The proper treatment of interest expense is often less than clear. Interest on debt held for investment is limited to the taxpayer's net investment income. A tax expert system would determine the investment income, investment expenses, and any limitation on deduction of investment interest.

Determination of a Passive Activity. The complexity and the frequency of need for assistance in the area of tax treatment of passive activities provides fertile ground for the development of a tax expert system. The system could aid in the determination of what constitutes an activity under IRC Sec. 469, and when it might be advantageous to aggregate activities.

The requirement of material participation and the special rules for rental activities provide the potential for the system to be constructed as separate modules. Incorporated into this system would be the at-risk provisions under IRC Sec. 465.

Imputed Interest on Below-Market Loans. A tax expert system would be beneficial in the determination of whether interest must be imputed under IRC Sec. 7872. Depending upon the nature and amount of the loan, the expert system could calculate the interest and the amount and character of the deemed transfer.

Excess Alimony Payments. To prevent payments in a divorce from qualifying for alimony treatment, a special recapture provision applies to "excess" alimony payments.

The knowledge base of an expert system in this area would incorporate the statutory formula and exceptions to the recapture rule. This system could also aid in property settlements by determining the manner and timing of various payments.

The expert systems discussed above would provide practitioner with an answer to a specific question, the starting point in tax compliance work.

Problem Identification/Planning

The development of tax expert systems in the area of identification and planning could prove to be the most useful. The various provisions of tax law which have multiple tests that must be satisfied to receive a prescribed treatment lend themselves to expert system development. These provision can range from the simple to the complex.

S Corporations. The provisions of IRC Sec. 1361 must be met for a corporation to be taxed as an S corporation. The knowledge base of an expert system could be comprised of the statutory requirements, regulations, and case law to identify if the requirements are met.

Personal Holding Company. The IRC Sec. 541 subjects a corporation that is a personal holding company (PHC) to a 28% penalty tax. A tax expert system could be utilized to determine whether or not PHC status was met, and if so, the extent and timing of needed distributions to avoid the penalty tax.

Lease vs. Purchase. A tax expert system, where the tax consequences are included in the present-value analysis, would provide the needed information in making decisions concerning whether to lease or purchase assets. Alternatives for decision making and potential tax savings would vary based on the time value of money, purchase price, cash requirements, depreciation methods, and tax rate.

Deduction Planning. A tax expert system providing alternative results for various levels of deduction would be valuable for a corporation to plan the amount of charitable contributions, contributions to a retirement plan, or the payment of bonuses to employees.

For example, when considering bonus payments, the amount of deduction generated would also include payroll taxes and any additional expenses such as compensation premiums resulting from the increase in wages.

Advantages from Using Expert Systems

There are several advantages in using these type of tax expert systems. First a tax expert system of this type will preserve the knowledge captured in the system's knowledge base. Until the applicable tax law changes, the system will supply the correct answer to any difficult tax issue for which the expert system was developed. When the law does change, the rules in the knowledge base can be modified to reflect those changes.

Second, the use of tax expert systems such as those described in this article will allow distribution of the tax expertise stored in the system. Large accounting firms could supply the system to all their offices scattered across the country. Software vendors and developers could make the systems available to local practitioners throughout the country.

Local practitioners can conceivably enjoy an added benefit by using expert systems to bring expertise it might not otherwise have to solve a particular complex tax issue. An expert system could quickly and inexpensively supply the local accounting firm with the necessary information to respond to the unusual tax problem.

Tax expert systems of the type described can also benefit non-accounting business and individuals as well. Companies faced with complex transactions can determine the tax consequences of handling a particular transaction in several different ways and then select the most appropriate method to minimize the tax effect of the transaction. Individuals could perform the same type of analysis for their personal tax situation.

A New Breed

To date, tax expert systems have been developed to aid in various taxation issues and areas. In the future a different type of expert system will be constructed. This new type of system will capture the applicable IRC section pertaining to a tax issue in the system's knowledge base and will be able to solve complex tax issues quickly and inexpensively.

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