Chapter 03 - Tax Planning Strategies and Related Limitations

Chapter 3
Tax Planning Strategies and Related Limitations
SOLUTIONS MANUAL
Problems
(32) [LO2, LO3 PL!!"!#$ "sa%el, a &alendar-'ear taxpa'er, (ses the &ash method o)
a&&o(nting )or her sole proprietorship* "n late +e&em%er she re&ei,ed a -20,000 %ill )rom
her a&&o(ntant )or &ons(lting ser,i&es related to her small %(siness* "sa%el &an pa' the
-20,000 %ill an'time %e)ore .an(ar' 30 o) next 'ear /itho(t penalt'* ss(me her
marginal tax rate is 00 per&ent this 'ear and next 'ear, and that she &an earn an a)ter-tax
rate o) ret(rn o) 12 per&ent on her in,estments* 2hen sho(ld she pa' the -20,000 %ill
this 'ear or next3
Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in preent !alue tax
a!ing"
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
= $20,000 ' $8,000 = $12,000
Option 2: Pay $20,000 bill in +anuary:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax a!ing in one
year"
Preent (alue o$ )ax *a!ing = $8,000 x "8,- .Dicount /actor, 1 0ear, 12 percent1
= $2,144
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
= $20,000 ' $2,144 = $12,834
Paying t5e $20,000 in December i t5e clear 6inner"
(33) [LO2, LO3 PL!!"!#$ 4sing the )a&ts )rom the pre,io(s pro%lem, ho/ /o(ld 'o(r
ans/er &hange i) "sa%el5s a)ter-tax rate o) ret(rn /ere 6 per&ent3
Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in preent !alue tax
a!ing"
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
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Chapter 03 - Tax Planning Strategies and Related Limitations
= $20,000 ' $8,000 = $12,000
Option 2: Pay $20,000 bill in +anuary:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax a!ing in one
year"
Preent (alue o$ )ax *a!ing = $8,000 x ",24 .Dicount /actor, 1 0ear, 8 percent1
= $2,408
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
= $20,000 ' $2,408 = $12,3,2
Paying t5e $20,000 in December i t5e clear 6inner"
(30) [LO2,LO3 PL!!"!#$ 7ann', a &alendar-'ear taxpa'er, (ses the &ash method o)
a&&o(nting )or his sole proprietorship* "n late +e&em%er he per)ormed -20,000 o) legal
ser,i&es )or a &lient* 7ann' t'pi&all' re8(ires his &lients to pa' his %ills immediatel'
(pon re&eipt* ss(me 7ann'5s marginal tax rate is 00 per&ent this 'ear and next 'ear,
and that he &an earn an a)ter-tax rate o) ret(rn o) 12 per&ent on his in,estments* Sho(ld
7ann' send his &lient the %ill in +e&em%er or .an(ar'3
Option 1: *end $20,000 bill in December:
$20,000 taxable income x 40 percent marginal tax rate = $8,000 in preent !alue tax
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $8,000 = $12,000
Option 2: *end $20,000 bill in +anuary:
$20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one
year"
Preent (alue o$ )ax = $8,000 x "8,- .Dicount /actor, 1 0ear, 12 percent1
= $2,144
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $2,144 = $12,834
*ending t5e $20,000 bill in +anuary i t5e clear 6inner"
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Chapter 03 - Tax Planning Strategies and Related Limitations
(39) [LO2,LO3 PL!!"!#$ 4sing the )a&ts )rom the pre,io(s pro%lem, ho/ /o(ld 'o(r
ans/er &hange i) 7ann'5s a)ter-tax rate o) ret(rn /ere 6 per&ent3
Option 1: *end $20,000 bill in December:
$20,000 taxable income x 40 percent marginal tax rate = $8,000 in preent !alue tax
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $8,000 = $12,000
Option 2: *end $20,000 bill in +anuary:
$20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one year"
Preent (alue o$ )ax = $8,000 x ",24 .Dicount /actor, 1 0ear, 8 percent1
= $2,408
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $2,408 = $12,3,2
*ending t5e $20,000 bill in +anuary i t5e clear 6inner"
(3:) [LO2, LO3 PL!!"!#$ Reese, a &alendar-'ear taxpa'er, (ses the &ash method o)
a&&o(nting )or her sole proprietorship* "n late +e&em%er she re&ei,ed a -20,000 %ill )rom
her a&&o(ntant )or &ons(lting ser,i&es related to her small %(siness* Reese &an pa' the
-20,000 %ill an' time %e)ore .an(ar' 30 o) next 'ear /itho(t penalt'* ss(me Reese5s
marginal tax rate is 30 per&ent this 'ear and /ill %e 00 per&ent next 'ear, and that she &an
earn an a)ter-tax rate o) ret(rn o) 12 per&ent on her in,estments* 2hen sho(ld she pa'
the -20,000 %illthis 'ear or next3
Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x -0 percent marginal tax rate = $4,000 in preent !alue tax
a!ing"
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
= $20,000 ' $4,000 = $14,000
Option 2: Pay $20,000 bill in +anuary:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax a!ing in one
year"
Preent (alue o$ )ax *a!ing = $8,000 x "8,- .Dicount /actor, 1 0ear, 12 percent1
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Chapter 03 - Tax Planning Strategies and Related Limitations
= $2,144
#$ter%tax cot = Pretax &ot ' Preent (alue )ax *a!ing
= $20,000 ' $2,144 = $12,834
Paying t5e $20,000 in +anuary i t5e clear 6inner"
(36) [LO2, LO3 PL!!"!#$ ;an<, a &alendar-'ear taxpa'er, (ses the &ash method o)
a&&o(nting )or his sole proprietorship* "n late +e&em%er he per)ormed -20,000 o) legal
ser,i&es )or a &lient* ;an< t'pi&all' re8(ires his &lients to pa' his %ills immediatel' (pon
re&eipt* ss(me his marginal tax rate is 30 per&ent this 'ear and /ill %e 00 per&ent next
'ear, and that he &an earn an a)ter-tax rate o) ret(rn o) 12 per&ent on his in,estments*
Sho(ld ;an< send his &lient the %ill in +e&em%er or .an(ar'3
Option 1: *end t5e $20,000 bill in December:
$20,000 taxable income x -0 percent marginal tax rate = $4,000 in preent !alue tax
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $4,000 = $14,000
Option 2: *end t5e $20,000 bill in +anuary:
$20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one
year"
Preent (alue o$ )ax = $8,000 x "8,- .Dicount /actor, 1 0ear, 12 percent1
= $2,144
#$ter%tax income = Pretax income ' Preent (alue )ax
= $20,000 ' $2,144 = $12,834
*ending t5e $20,000 bill in December i t5e clear 6inner"
(00) [LO3 PL!!"!#$ =o%5s Lotter', "n&*, has de&ided to o))er /inners a &hoi&e o)
-100,000 in ten 'ears or some amo(nt &(rrentl'* ss(me that =o%5s Lotter', "n&*, earns a
10 per&ent a)ter-tax rate o) ret(rn* 2hat amo(nt sho(ld =o% o))er lotter' /inners
&(rrentl', in order )or him to %e indi))erent %et/een the t/o &hoi&es3
$100,000 in ten year i 6ort5 $-8,400 today to 7ob .$100,000 x "-84 .Dicount
/actor, 10 0ear, 10 percent11" )5u, 7ob 5ould o$$er lottery 6inner $-8,400 today
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Chapter 03 - Tax Planning Strategies and Related Limitations
$or 5im to be indi$$erent bet6een t5e t6o c5oice"
(09) [LO0 PL!!"!#$ Ta/ana o/ns and operates a sole proprietorship and has a 00
per&ent marginal tax rate* She pro,ides her son, .onathon, -6,000 a 'ear )or &ollege
expenses* .onathon /or<s as a pi>>a deli,er' person e,er' )all and has a marginal tax
rate o) 19 per&ent* 2hat &o(ld Ta/ana do to red(&e her )amil' tax %(rden3 ;o/ m(&h
pretax in&ome does it &(rrentl' ta<e Ta/ana to generate the -6,000 a)ter-taxes gi,en to
.onathon3 ") .onathon /or<ed )or his mother5s sole proprietorship, /hat salar' /o(ld
she ha,e to pa' him to generate -6,000 a)ter taxes (ignoring an' So&ial Se&(rit',
7edi&are, or sel)-emplo'ment tax iss(es)3 ;o/ m(&h mone' /o(ld this strateg' sa,e3
)a6ana could reduce 5er $amily8 tax burden by employing 5er on in 5er ole
proprietor5ip, t5u 5i$ting income taxed at 40 percent .)a6ana8 marginal tax
rate1 to 13 percent .+onat5on8 tax rate1" 9t currently ta:e )a6ana $1-,--- o$
pretax income to generate t5e $8,000 a$ter%taxe gi!en to +onat5on"
#$ter%tax income = Pretax income x .1 ' marginal tax rate1
$8,000 = Pretax income x .1 ' "401
Pretax income = $8,000 ; ."401 = $1-,---"
9$ +onat5on 6or:ed $or )a6ana8 ole proprietor5ip, 5e 6ould only 5a!e to pay
5im $,,412 to generate $8,000 a$ter%taxe"
#$ter%tax income = Pretax income x .1 ' marginal tax rate1
$8,000 = Pretax income x .1 ' "131
Pretax income = $8,000 ; ."831 = $,,412"
)5i trategy 6ill a!e )a6ana $-,,21 pretax .i"e", $1-,--- ' $,,4121 and $2,-3- a$ter
tax .$-,,21 x .1 ' "4011"
(0:) [LO0 PL!!"!#$ 7oana is a single taxpa'er /ho operates a sole proprietorship* She
expe&ts her taxa%le in&ome next 'ear to %e -290,000, o) /hi&h -200,000 is attri%(ted to
her sole proprietorship* 7oana is &ontemplating in&orporating her sole proprietorship*
4sing the single indi,id(al tax %ra&<ets and the &orporate tax %ra&<ets, )ind o(t ho/
m(&h &(rrent tax this strateg' &o(ld sa,e 7oana (ignore an' So&ial Se&(rit', 7edi&are,
or sel)-emplo'ment tax iss(es)* ;o/ m(&h in&ome sho(ld %e le)t in the &orporation3
#uming <oana8 goal i to minimi=e 5er current $ederal income tax expoure, one
can compare t5e ingle indi!idual and corporate tax rate c5edule to ac5ie!e t5i
goal" *ince <oana 5a $30,000 o$ taxable income not related to 5er ole
proprietor5ip, 5e i currently in t5e 23 percent tax brac:et" )5e ta: i to allocate
t5e $200,000 bet6een <oana and 5er corporation to minimi=e 5er current liability"
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Chapter 03 - Tax Planning Strategies and Related Limitations
)5e lo6et corporate tax rate i 13 percent .taxable income $rom 0 to $30,0001 and i
lo6er t5an <oana8 marginal tax rate o$ 23 percent" )o ta:e ad!antage o$ t5e 13
percent corporate tax brac:et, $30,000 o$ t5e expected $200,000 in pro$it 5ould be
retained in t5e corporation" >$30,000 i t5e 6idt5 o$ t5e 13 percent corporate tax
brac:et"? #uming t5e corporation retain $30,000 o$ pro$it, t5e corporation8
marginal tax rate 6ould no6 be 23 percent and t5u, <oana8 c5oice i to 5a!e
income taxed at 23 percent .t5e corporation8 marginal tax rate1 or 23 percent
.<oana8 marginal tax rate1" @et8 aume t5at, all t5ing eAual, <oana pre$er to
recei!e t5e pro$it peronally" )o ta:e ad!antage o$ <oana8 23 percent peronal
tax brac:et, t5e next $--,400 o$ t5e expected $200,000 in pro$it 5ould be 5i$ted to
<oana" >$--,400 i t5e remaining 6idt5 o$ <oana8 23 percent tax brac:et?"
<oana8 marginal tax rate 6ould no6 be 28 percent" &ontinuing t5i ame deciion
proce, $23,000 o$ t5e remaining $114,400 o$ pro$it 5ould be retained by t5e
corporation, and t5e ret .$,1,4001 5ould be 5i$ted to <oana" 9n ummary,
$23,000 o$ t5e expected pro$it are retained in t5e corporation and $123,000 o$ t5e
pro$it are 5i$ted to <oana"
)5i trategy 6ill a!e <oana $11,000 calculated a:
.a1 )5e tax on $230,000 o$ taxable income reported
by <oana auming t5at 5e operate 5er buine
a a ole proprietor5ip" $42,-,2
@e:
.b1 )5e tax on $123,000 o$ taxable income reported
by <oana auming t5at 5e incorporate 5er buine ? $42,442
and .c1 t5e tax on $23,000 pro$it retained in t5e corporation ? $1-,230
= $11,000
(0@) [LO0 PL!!"!#$ Orie and .ane, h(s%and and /i)e, operate a sole proprietorship*
The' expe&t their taxa%le in&ome next 'ear to %e -2@9,000, o) /hi&h -129,000 is
attri%(ted to the sole proprietorship* Orie and .ane are &ontemplating in&orporating their
sole proprietorship* 4sing the married-Aoint tax %ra&<ets and the &orporate tax %ra&<ets,
)ind o(t ho/ m(&h &(rrent tax this strateg' &o(ld sa,e Orie and .ane* ;o/ m(&h in&ome
sho(ld %e le)t in the &orporation3
#uming Orie and +ane8 goal i to minimi=e t5eir current $ederal income tax
expoure, one can compare t5e married $iling Boint and corporate tax rate c5edule
to ac5ie!e t5i goal" *ince Orie and +ane 5a!e $130,000 o$ taxable income not
related to t5eir ole proprietor5ip, t5ey are currently in t5e 28 percent tax brac:et"
)5e ta: i to allocate t5e $123,000 bet6een Orie and +ane and t5eir corporation to
minimi=e t5eir current liability" )5e lo6et corporate tax rate i 13 percent .taxable
income $rom 0 to $30,0001 and i lo6er t5an Orie and +ane8 marginal tax rate o$ 28
percent" )o ta:e ad!antage o$ t5e 13 percent corporate tax brac:et, $30,000 o$ t5e
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Chapter 03 - Tax Planning Strategies and Related Limitations
expected $123,000 in pro$it 5ould be retained in t5e corporation" >$30,000 i t5e
6idt5 o$ t5e 13 percent corporate tax brac:et"? #uming t5e corporation retain
$30,000 o$ pro$it, t5e corporation8 marginal tax rate 6ould no6 be 23 percent and
t5u, Orie and +ane8 c5oice i to 5a!e income taxed at 23 percent .t5e corporation8
marginal tax rate1 or 28 percent .Orie and +ane8 marginal tax rate1" 23 percent i
t5e ob!iou c5oice" )o ta:e ad!antage o$ t5e corporation8 23 percent tax brac:et,
t5e next $23,000 o$ t5e expected $123,000 in pro$it 5ould be retained in t5e
corporation" >$23,000 i t5e 6idt5 o$ t5e 23 percent corporate tax brac:et?" )5e
corporation8 marginal tax rate 6ould no6 be -4 percent" &ontinuing t5i ame
deciion proce, t5e remaining $30,000 o$ pro$it 5ould be 5i$ted to Orie and
+ane" 9n ummary, $23,000 o$ t5e expected pro$it are retained in t5e corporation
and $30,000 o$ t5e pro$it are 5i$ted to Orie and +ane"
)5i trategy 6ill a!e Orie and +ane $10,-83 calculated a:
.a1 )5e tax on $223,000 o$ taxable income reported
by Orie and +ane auming t5at t5ey operate t5eir buine
a a ole proprietor5ip" $48,204"30
@e:
.b1 )5e tax on $200,000 o$ taxable income reported
by Orie and +ane auming t5at t5ey incorporate t5e buine ? $44,04,"30
and .c1 t5e tax on $23,000 pro$it retained in t5e corporation ? $1-,230"00
= $10,-83"00
(06) [LO0 PL!!"!#$ ;'(ndai is &onsidering opening a plant in t/o neigh%oring states*
One state has a &orporate tax rate o) 10 per&ent* ") operated in this state, the plant is
expe&ted to generate -1,000,000 pretax pro)it* The other state has a &orporate tax rate o)
2 per&ent* ") operated in this state, the plant is expe&ted to generate -B30,000 o) pretax
pro)it* 2hi&h state sho(ld ;'(ndai &hoose3 2h' do 'o( thin< the plant in the state /ith
a lo/er tax rate /o(ld prod(&e a lo/er %e)ore-tax in&ome3
Cyundai 5ould c5ooe to operate t5e plant in t5e tate 6it5 t5e 2 percent tax rate"
Operating t5e plant in t5i tate 6ould generate $,11,400 o$ pro$it a$ter tate taxe
.i"e", $,-0,000 ' .2 percent x $,-0,0001 = $,11,40011 !eru $,00,000 o$ pro$it a$ter
tate taxe .i"e", $1,000,000 ' .10 percent x $1,000,0001 = $,00,0001 in t5e tate 6it5
t5e 10 percent tax rate"
)5e tate 6it5 a lo6er tax rate produce a lo6er pretax income becaue t5e demand
$or 6or:er, er!ice, property, etc" in t5e lo6%tax rate tate Buridiction 5a mot
li:ely increaed t5e cot aociated 6it5 operating a buine in t5i tate" )5ee
increaed cot are conidered implicit taxe and reduce t5e tax ad!antage o$
operating in t5e lo6 tax rate tate"
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Chapter 03 - Tax Planning Strategies and Related Limitations
(91) [LO9 PL!!"!#$ +ennis is &(rrentl' &onsidering in,esting in m(ni&ipal %onds that
earn : per&ent interest, or in taxa%le %onds iss(ed %' the Co&a-Cola Compan' that pa' 6
per&ent* ") +ennis5 tax rate is 20 per&ent, /hi&h %ond sho(ld he &hoose3 2hi&h %ond
sho(ld he &hoose i) his tax rate is 30 per&ent3 t /hat tax rate /o(ld he %e indi))erent
%et/een the %onds3 2hat strateg' is this de&ision %ased (pon3
Denni8 a$ter%tax rate o$ return on t5e tax exempt bond i 4 percent .i"e", t5e ame a
it pretax rate o$ return1" )5e &oca%&ola &ompany bond pay taxable interet o$ 8
percent" Denni8 a$ter%tax rate o$ return on t5e &oca%&ola &ompany bond i 4"4
percent .i"e", 8 percent interet income ' .8 percent x 20 percent1 tax = 4"4 percent1"
Denni 5ould in!et in t5e &oca%&ola &ompany bond"
9$ Denni8 marginal tax rate i -0 percent, 5i a$ter%tax rate o$ return on t5e &oca%
&ola &ompany bond 6ould be 3"4 percent .i"e", 8 percent interet income ' .8
percent x -0 percent1 tax = 3"4 percent1" Denni 5ould in!et in t5e tax exempt
bond in t5i ituation"
Denni 6ould be indi$$erent bet6een t5e t6o bond i$ 5i marginal tax rate i 23
percent"
#$ter%tax return = Pretax return x .1 ' marginal tax rate1
4 percent = 8 percent x .1 ' marginal tax rate1 = 8 percent ? .8 percent x marginal
tax rate1
8 percent marginal tax rate = 2 percent
marginal tax rate = 2 percent ; 8 percent = 23 percent
)5i example i an illutration o$ t5e con!erion planning trategy"
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