04 Chapter - Maxims of Income Tax Planning
Chapter 4 Maxims of Income Tax Planning
Application Problems
1.
a. Tax liability $7,245; marginal rate 15%; average rate 15%.
b. Tax liability $209,372; marginal rate 34%; average rate 34%.
c. Tax liability $5,533,800; marginal tax rate 38%; average tax rate 34.56%.
d. Tax liability $13,738,550; marginal rate 35%; average rate 35%.
2.
a. Tax liability $6,948; marginal rate 15%; average rate 13.39%.
b. Tax liability $46,563; marginal rate 33%; average rate 25.01%.
c. Tax liability $130,523; marginal rate 35%; average rate 29.25%.
3.
a. The income tax savings equals $3,820
b. Ms. JKs gift of the interest coupon does not shift the income represented by the coupon to
Alison because Ms. JK retains the bond. Therefore, the gift does not result in any income tax
savings.
c. Ms. JKs gift of the rent check does not shift the income represented by the check to Alison
because Ms. JK retains the rental property. Therefore, the gift does not result in any income
tax savings.
d
4.
The income tax savings equals $1,180
a. If Firm A incurs the $9,500 expense, the after-tax cost is $8,075
b. If Firm Z incurs the $9,500 expense, the after-tax cost is $6,840
5.
a. $59,500
b. $74,800
c. Under the assignment of income doctrine, the $85,000 income generated by the service
contract must be taxed to Company G because Company G performed the services.
Therefore, Company G must pay $25,500 tax (negative cash flow), even though Company J
receives the $85,000 cash.
6.
BPKs after-tax cost of a $72,000 deductible expense is $54,000. OPKs after-tax cost of a
$92,500 deductible expense is $55,500. Therefore, BPK should incur the expense to minimize
its after-tax cost.
7.
If Firm M engages in the transaction, the annual after-tax profit is $6,600. If the transaction is
restructured to shift the income to Firm N, the annual after-tax profit is $6,750. Therefore, Firm M
should restructure the transaction to maximize after-tax profit.
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Chapter 04 - Maxims of Income Tax Planning
8.
$46,864
b. NPV
$44,886
c. NPV
9.
a. NPV
$47,712
Original transaction: NPV $66,000
Restructured transaction: NPV $70,505
10. Restructured transaction: NPV $68,440
11. Original structure of transaction: $236,304 NPV
Restructured transaction: $231,910 NPV
Corporation R should not agree to restructure the transaction because restructuring would
reduce NPV.
12. Province P:
After-tax profit per bike
$150
Province W:
After-tax profit per bike.
$143
Company EJ should build its new plant in Province P to maximize after-tax profit per bike.
13. a.
Motos total tax is $1,099,710 ($97,300 foreign + $158,442 state + $843,968 federal).
b.
Motos total tax is $1,103,563 ($97,300 foreign + $164,280 state + $841,983 federal).
c.
Motos total tax is $1,136,645 ($97,300 foreign + $164,280 state + $875,065 federal).
14. a. Mr. Gs before-tax and after-tax yield on the tax-exempt bonds is 7 percent. His after-tax
yield on the corporate bonds is 6.365 percent (9.5% before-tax yield [9.5% 33%
marginal tax rate]). Therefore, he should invest in the municipal bonds.
b. In this case, Mr. Gs after-tax yield on the corporate bonds is 8.075 percent (9.5% before-tax
yield [9.5% 15% marginal tax rate]). Therefore, he should invest in the corporate bonds.
15. The value of the preferential rate is $650
16. a. Mr. L paid a $1,000 implicit tax.
b. Mr. Ls after-tax return on his investment was $4,250 ($5,000 return $750 tax). His after-tax
return from the business would have been $4,320 ($6,000 return $1,680 tax). Therefore,
he made an incorrect investment decision. Another way to reach the same conclusion is to
compare Mr. Ls $1,000 implicit tax on his investment with the $650 value of the preferential
rate on that investment.
17. a. Ms. A will save $1,200.
b. Mr. B will save $1,950.
c. Mr. C not save any tax because of the new preferential rate.
d. Mrs. D will save $5,600.
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Chapter 04 - Maxims of Income Tax Planning
18. a. Firm L pays $22,750 explicit tax and no implicit tax on Investment A and no explicit tax and
$17,500 tax implicit on investment B. The implicit tax is the $17,500 difference between the
before-tax rates of return on the taxable investment and the tax-exempt investment.
b. Because the explicit tax on Investment A exceeds the implicit tax on Investment B, Firm L
should invest in the latter. Investment A results in $42,250 after-tax cash flow ($65,000
$22,750 explicit tax), while Investment B results in $47,500 after-tax cash flow.
19. Business operated by Firm W: NPV
$74,791
Business operated by Entity N: NPV
$79,990
Firm W maximizes NPV by forming Entity N to operate the business.
Issue Recognition Problems
1.
Do Mr. and Mrs. TR have the same marginal tax rate as Ms. K? Would Mr. and Mrs. TR pay
implicit tax on an investment in Ms. Ks tax-preferred business (in the form of a reduced beforetax rate of return) that exceeds the explicit tax on their current investment?
2.
Does the tax benefit of operating in Country B rather than Country C justify the risk of operating
in a unstable political and financial environment? To what extent would the before-tax rate of
return on the manufacturing plant in Country B be reduced because of the unstable political and
financial environment?
3.
Do the payments from Dr. Ps patients to his daughter shift income from Dr. P to the daughter?
Who must report and pay tax on the income represented by the payments to the daughter?
Does Dr. Ps tax strategy violate the assignment of income doctrine?
4.
What is the probability that the $27 market price will hold stable until January? Is Mrs. Y willing to
accept the market risk inherent in the two-month delay to defer tax on her gain for one year?
5.
Does the sale of land by Corporation Q to its subsidiary have an independent business purpose
or was the sole reason for the sale to accelerate Qs gain into the current year? If the IRS audits
the tax returns reflecting the two sales, could it collapse the two transactions into a single sale of
the land by Q to the unrelated buyer that occurred in February of the next year?
6.
Does the gift of the rent checks shift rent income from Mr. and Mrs. K to their grandson? Who
must report and pay tax on the income represented by the rent checks?
7.
What is the probability that the IRS will audit the tax returns reflecting Firm Zs aggressive
strategy? How frequently has the IRS audited Firm Z in the past? If the IRS does disallow the
intended tax outcome of the aggressive strategy, can Firm Z alter or reverse the strategy at a
reasonable cost? If Firm Z can alter or reverse the strategy, will before-tax cash flows increase?
8.
Could the IRS invoke the substance-over-form doctrine to require Ms. LG to report the
transaction as a lease rather than as a sale? If Ms. LGs tax position does change, can she
invoke this doctrine by ignoring the legal form of the transaction (which she deliberately
structured as a sale) and treat it as a lease for tax purposes?
9.
Will Firm HR reduce its exposure to the step-transaction doctrine by delaying the second phase
of its business strategy from August to January? What are the nontax costs of the delay?
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Chapter 04 - Maxims of Income Tax Planning
Tax Planning Cases
1. If Ms. Z invests in the State A bonds, her before- tax and after-tax return is $3,750. If she invests
in the state R bonds, her after-tax return is $3,820.
2.
If DFG operates in Country X, the NPV of the operation (ignoring terminal value) is $ 166,947
If DFG operates in Country Y, the NPV of the operation (ignoring terminal value) is $ 177,386
DFG should locate the subsidiary in Country Y to maximize NPV.
3.
Investment 1: NPV $1,255
Investment 2: NPV $5,005
4.
If DC Company sells the land to Mrs. O this year, it will realize $693,500 after-tax cash.
DC's alternative is to reject Mrs. O's offer and hope to sell the land at its appraised FMV next
year. In this case, DC will realize only $672,000 after-tax cash.
Even ignoring the fact that DC will receive the cash next year, this alternative results in less
after-tax cash. Consequently, it should accept Mrs. Os offer.
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