Chapter 03

1. Chapter 03 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 non-tax factors • In general terms, effective tax planning maximizes the taxpayer’s after-tax wealth while achieving the taxpayer’s non-tax goals • 3 parties to every transaction: taxpayer, other party, and the government • 3 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 • 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 • 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 • Two basic tax-related timing strategies: • Accelerating deductions • Essentially accelerating a current cash inflow • Deferring income • Essentially deferring a current cash outflow

9. Timing Strategies When Tax Rates Change • When tax rates are increasing, the taxpayer must calculate the optimal tax strategies for deductions and income. Why? • When tax rates are decreasing, taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years. Why?

10. 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

11. 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 • Transactions between owners and their businesses • Transactions across jurisdictions • Several factors limit this strategy

12. 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

13. Limitations of Conversion Strategies • The Code itself also contains provisions to prevent a taxpayer from changing the nature of expenses and income • Implicit taxes • Judicial doctrines

14. Additional Limitations to Tax Planning Strategies: Judicial Doctrines • Constructive Receipt • Assignment of income • Related-party transactions • Business purpose doctrine • Step-transaction doctrine • Substance-over-form doctrine • Economic substance doctrine

15. Tax Avoidance vs. Tax Evasion • The previous strategies fall into legal tax avoidance. • Tax evasion: the willful attempt to defraud the government