Chapter 3

Tax Planning Strategies and Related Limitations

2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Learning Objectives

Identify the objectives of basic tax planning strategies. Apply the timing strategy and describe its applications and limitations. Apply the concept of present value to tax planning. Apply the strategy of income shifting, provide examples, and describe its limitations.
3-2

Learning Objectives (Cont.)

Apply the conversion strategy, provide examples, and describe its limitations. Describe basic judicial doctrines that limit tax planning strategies. Contrast tax avoidance and tax evasion

3-3

Basic Tax Planning Overview

Effective planning requires consideration for both tax and non-tax factors In general terms, effective tax planning maximizes the taxpayers after-tax wealth while achieving the taxpayers non-tax goals 3 parties to every transaction: taxpayer, other party, and the government 3 basic planning strategies: timing, income shifting, and conversion
3-4

Timing Strategies

When income is taxed or an expense is deducted affects the associated real tax costs or savings for 2 reasons

(1) the time that income is taxed or an expense is deducted affects the present value of the taxes paid on income or the tax savings on deductions. (2) the tax costs of income and tax savings income vary as tax rates change

3-5

Timing Strategies

The concept of Present Value.

$1 today is worth more than $1 in the future.

The implication of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense When considering cash inflows, higher present values are preferred; when considering cash outflows, lower present values are preferred

3-6

Timing Strategies

Present Value = Future Value / (1 + r)n Exhibit 3-1 provides the discount rates for a lump sum (single payment) received in n periods using various rates of return

3-7

Timing Strategies Present Value Example

At a recent holiday sale, Bill and Mercedes purchase $1,000 worth of furniture with no money down and no payments for one year! How much money is this deal really worth? (Assume their after-tax rate of return on investments is 10%.) The discount rate of .909 (Exhibit 3-1, 10% interest rate column, year 1 row) means the present value of $1,000 is $909 ($1,000 x .909 = $909) so Bill and Mercedes save $91 ($1,000 - $909 = $91).
3-8

Timing Strategies

Two basic tax-related timing strategies:

Accelerating deductions

Essentially accelerating a current cash inflow Essentially deferring a current cash outflow

Deferring income

3-9

Timing Strategies Example

Mercedes, a calendar year taxpayer, uses the cashbasis method of accounting for her small business. On December 28th, she receives a $10,000 bill from her accountant for consulting services related to her small business. She can avoid late payment charges by paying the $10,000 bill before January 10th of next year. Assume that Mercedes marginal tax rate is 30% this year and next and that she can earn an after-tax rate of return of 10% on her investments. When should she pay the $10,000 bill this year or next?
3-10

Timing Strategies Example

Mercedes should pay the bill this year

Present value tax savings if pay this year: $10,000 x 30% = $3,000 Present value tax savings if pay next year: $10,000 x 30% x .909 = $2,727

3-11

Timing Strategies When Tax Rates Change

When tax rates are increasing, the taxpayer must calculate the optimal tax strategies for deductions and income. Why?

The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower tax rate year. The taxpayer must calculate whether the benefit of deferring income outweighs the disadvantage of recognizing income in a higher tax rate year.
3-12

Timing Strategies When Tax Rates Change

When tax rates are decreasing, taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years. Why?

Accelerating deductions maximizes the present value of tax savings from deductions due to the acceleration of the deductions into earlier years with a higher tax rate year. Deferring income minimizes the present value of taxes paid due to the deferral of the income to later years with a lower tax rate.

3-13

Tax Rate Change

Having decided she needs new equipment for her business, Mercedes is now considering whether to make the purchase and take a corresponding $10,000 deduction at year end or next year. Mercedes anticipates that, with the new machinery, her business income will rise such that her marginal rate will increase from 20% this year to 28% next year. Assuming her after-tax rate of return is 8%, what should Mercedes do?

3-14

Tax Rate Change Solution

Mercedes should pay the $10,000 in January Tax savings in paid in December

$10,000 x 20% = $2,000 $10,000 x 28% = $2,800 Discount savings back to current year 2,800 * .826 = $2,593

Tax savings in paid in January

3-15

Limitations of Timing Strategies

The tax deduction often cannot be accelerated without the actual cash outflow that generates the deduction Tax law generally requires taxpayers to continue their investment to defer income Deferral strategy may not be optimal if taxpayer has cash flow needs, or if continuing investment generates low returns or subjects taxpayer to unnecessary risk Constructive receipt doctrine: taxpayer must recognize income when it is actually or constructively received

3-16

Income Shifting Strategies

Income shifting exploits the differences in tax rates across taxpayers by shifting income from high-tax rate taxpayers (jurisdictions) to low-tax rate taxpayers (jurisdictions) or shifting deductions from low-tax rate taxpayers (jurisdictions) to high-tax rate taxpayers (jurisdictions)

Transactions between family members

Children generally have lower marginal tax rates and therefore, parents may shift income to children so it will be taxed at the childs tax rate

3-17

Income Shifting Strategies

Transactions between owners and their businesses

Incorporating a business and thus shifting income from an individual to the corporation may result in lower current taxation of the business income [See Example 3-8] Shifting income from a corporation to an owner through tax deductible expenses (e.g., compensation, interest, rent) allows the owners to avoid double taxation on corporate profits
3-18

Income Shifting Strategies

Transactions across jurisdictions

Income earned in different jurisdictions is often taxed very differently. Taxpayers can use these differences to maximize their after-tax wealth

IRS scrutiny of related party transactions, implicit taxes, the kiddie tax, negative publicity, and judicial doctrines (assignment of income) limit income shifting strategies

3-19

Conversion Strategies

Tax rates can vary across different activities

Ordinary income is taxed at ordinary rates Long-term capital gains are taxed at preferential rates Some income is tax exempt

3-20

Conversion Strategies

The conversion strategy is based on the understanding that the tax law does not treat all types of income or deductions the same To implement the conversion strategy, you must:
Understand the differences in tax treatment across various types of income, expenses, and activities and Have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment

3-21

Conversion Example

Bill is contemplating three different investments, each with the same amount of risk: (A) a highdividend stock that pays 8% dividends annually with no appreciation potential, (B) taxable corporate bonds that pay 9% interest annually, (C) tax-exempt municipal bonds that pay 6% interest annually. Assume that dividends are taxed at 15% and that Bills marginal tax rate on ordinary income is 30%, which investment should Bill choose?
3-22

Conversion Example Solution

High-dividend Stock: 8% * (1 - 15%) = 6.8% Corporate Bond: 9% * (1 - 30%) = 6.3% Municipal Bond: 6% * (1- 0%) = 6%

Therefore, the high-dividend stock would give the highest return for the investment

3-23

Limitations of Conversion Strategies

The Code itself also contains provisions to prevent a taxpayer from changing the nature of expenses and income Implicit taxes may also reduce or eliminate the advantages of conversion strategies Judicial doctrines such as business purpose, step transactions, substance-over-form, and economic substance may limit use of conversion strategies
3-24

Additional Limitations to Tax Planning Strategies: Judicial Doctrines

Constructive Receipt (previously discussed) Assignment of income:

Requires income to be taxed to the taxpayer who actually earns the income Merely attributing a paycheck or dividend to another taxpayer does not transfer tax liability IRS scrutinizes these transactions because they are often not arms-length transactions
3-25

Related-party transactions:

Additional Limitations to Tax Planning Strategies: Judicial Doctrines

Business purpose doctrine:

IRS has the power to disallow business expenses for transactions that dont have a business purpose IRS has the power to collapse a series of transactions into one to determine tax liability IRS can reclassify a transaction according to its substance (instead of its form) Transactions must meet two criteria
1. 2.

Step-transaction doctrine:

Substance-over-form doctrine:

Economic substance doctrine:

Transaction must meaningfully change a taxpayers economic position (excluding any federal income tax effects) Taxpayer must have a substantial purpose (other than tax avoidance) for the transaction
3-26

Tax Avoidance vs. Tax Evasion

Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
Judge Learned Hand Commissioner vs. Newman

3-27

Tax Avoidance vs. Tax Evasion

The previous strategies fall into legal tax avoidance. Tax evasion: the willful attempt to defraud the government

This is outside the confines of legal tax avoidance May land the taxpayer in prison

3-28