Basic Maxims of Income Tax Planning: Legal Strategies and Entity Considerations

1. Chapter 4 Basic Maxims of Income Tax Planning

2. Tax Avoidance and Basic Tax Planning • Avoidance is legal • Tax evasion is a federal crime • This course teaches tax planning (avoidance), not evasion – • General Rule: Defer tax payments for as long as possible within the realm of the law

3. Income Tax Planning - Entity • Generally, taxable income is basically computed the same for different entities. • However, the amount of tax paid depends on the difference in tax rates across entities. The two primary tax paying entities are corporations and individuals.

4. Income Tax Planning - Entity • Individual taxpayers • have a progressive tax rate structure that ranges from 10% to 35% (as of May 2003) • see the inside front cover of text. Corporate taxpayers • have a progressive tax rate structure that ranges from 15% to 35% for richest corporations. • see the corporate tax rates in text. Marginal rates of 38% and 39% eliminate benefits of lower brackets.

5. Income Tax Planning - Entity • Income Shifting • Arrange transactions to transfer income from a high tax rate entity to a low tax rate entity or from a high rate tax year to a low tax rate year. • Deduction Shifting • Arrange transactions to transfer deductions from a low tax rate entity to a high tax rate entity or from a low rate tax year to a high rate tax year. • Assignment of Income Doctrine prohibits shifting of income from property UNLESS the property is transferred also. • Income shifting during periods of changing rates may compete with general tax deferral maxim.

6. Income Tax Planning - Time • Because income is reported only once a year, the tax paid or tax savings from any transaction depends on the year the transaction occurs. • In present value terms, tax costs decrease (and cash flows increase) when a tax liability is deferred until a later taxable year. Limited by: • Opportunity Costs • Tax Rate Changes

7. Income Tax Planning - Time • Opportunity Costs • Shifting tax liabilities to a later period also may entail shifting income to a later period. Thus, the opportunity costs of shifting the income may be greater than the tax savings associated with the liability deferral. • Tax Rate Changes • If taxpayers defer a tax liability to a future date and Congress increases tax rates the benefits of the deferral may be lost or substantially limited.

8. Income Tax Planning - Character • Ordinary income: generated by the routine operations of a business or investment activity and is subject to tax at regular tax rates. This includes service income, sales, interest, royalties, and rents. • Capital income generated by the sale of capital assets (see chapter 8) and has consistently been subject to lower tax rates than ordinary income. (e.g. 15% for individuals) (Now some dividends too) • Some income is nontaxable. E.g.: Municipal bond income, many fringe benefits. • Taxpayers look to convert ordinary income into capital where possible for rate benefit.

9. Tax Law Doctrines - • Business Purpose Doctrine - must have a business purpose other than tax avoidance. • Substance Over Form Doctrine - IRS can look through legal formalities to determine economic substance. • Ability to Pay Doctrine: Generally requires a realization transaction to have item subject to tax • Return of Capital Doctrine: Return of original investment made with after tax dollars not subject to tax.