Tax Planning Strategies and Related Limitations

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Chapter 03

• Tax Planning Strategies and Related Limitations

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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

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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

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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

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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

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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).

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Timing Strategies

• Two basic tax-related timing strategies
• Accelerating deductions
• Essentially accelerating a current cash inflow
• Deferring income
• Essentially deferring a current cash outflow

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Timing Strategies Example

• Mercedes, a calendar year taxpayer, uses the
  cash-basis 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?

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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
• Alternative thinking If pay the bill this year,
  3,000 is saved on taxes. One year later, it
  becomes 3,300 (i.e., 3,000 x 1.10). However,
  only 3,000 extra tax should be paid then. So,
  300 would be the benefit.

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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.

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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.

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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?

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Tax Rate Change Solution

• Mercedes should pay the 10,000 in January
• Tax savings in paid in December
• 10,000 x 20 2,000
• Tax savings in paid in January
• 10,000 x 28 2,800
• Discount savings back to current year
• 2,800 .926 2,593

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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

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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

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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

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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

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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

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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

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Conversion Example

• Bill is contemplating three different
  investments, each with the same amount of risk
  (A) a high-dividend 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?

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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

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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

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Additional Limitations to Tax Planning
Strategies Judicial Doctrines

• Constructive Receipt
• 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

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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
• 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)
• Economic substance doctrine
• Transactions must meet two criteria
• 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

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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

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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