Effective Tax Planning Strategies and Limitations Overview

1. Chapter 3 Tax Planning Strategies and Related Limitations

2. 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. 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.

4. Basic Tax Planning Overview • Effective planning requires consideration for both tax and nontax factors • In general terms, effective tax planning maximizes the taxpayer’s after-tax wealth while achieving the taxpayer’s nontax goals • Three parties to every transaction: taxpayer, other party, and the government • Three basic planning strategies: timing, income shifting, and conversion

5. 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

6. Timing Strategies (2) • 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

7. Timing Strategies (3) • 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

8. 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 × .909 = $909) – so Bill and Mercedes save $91 ($1,000 − $909 = $91).

9. Timing Strategies (4) • Two basic tax-related timing strategies: • Accelerating deductions • Essentially accelerating a current cash inflow • Deferring income • Essentially deferring a current cash outflow

10. Timing Strategies Example • Mercedes, a calendar-year taxpayer, uses the cash-basis method of accounting for her small business. On December 28, 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 10 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?

11. Timing Strategies Example (Cont.) • Mercedes should pay the bill this year • Present value tax savings if pay this year: $10,000 × 30% = $3,000 • Present value tax savings if pay next year: $10,000 × 30% × .909 = $2,727

12. 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

13. Timing Strategies When Tax Rates Change (Cont.) • 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

14. 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?

15. Tax Rate Change Solution • Mercedes should pay the $10,000 in January • Tax savings if paid in December • $10,000 × 20% = $2,000 • Tax savings if paid in January • $10,000 × 28% = $2,800 • Discount savings back to current year • 2,800 × .926 = $2,593

16. Limitations to 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

17. 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; therefore, parents may shift income to children so it will be taxed at the child’s tax rate

18. Income-Shifting Strategies (2) • 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

19. Income-Shifting Strategies (3) • 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

20. 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

21. Conversion Strategies (Cont.) • 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 • Have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment

22. Conversion Example • Bill is contemplating three different investments, each with the same amount of risk: (A) a high-dividend stock that pays 8.5% 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 20% and that Bill’s marginal tax rate on ordinary income is 30%. Which investment should Bill choose?

23. Conversion Example Solution • High-dividend stock: 8.5% × (1 − 20%) = 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

24. Limitations of Conversion Strategies • The Code itself 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

25. 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 • Related-party transactions: • IRS scrutinizes these transactions because they are often not arms-length transactions

26. Additional Limitations to Tax Planning Strategies: Judicial Doctrines (2) • Business purpose doctrine: • IRS has the power to disallow business expenses for transactions that don’t have a business purpose • Step-transaction doctrine: • IRS has the power to collapse a series of transactions into one to determine tax liability • Substance-over-form doctrine: • IRS can reclassify a transaction according to its substance (instead of its form) • Economicsubstance doctrine: • Transactions must meet two criteria • Transaction must meaningfully change a taxpayer’s economic position (excluding any federal income tax effects) • Taxpayer must have a substantial purpose (other than tax avoidance) for the transaction

27. Tax Avoidance Versus 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 v. Newman

28. Tax Avoidance Versus Tax Evasion (2) • 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