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3 Chapter - Tax Planning Strategies and Related Limitations Chapter 03 Tax Planning Strategies and Related Limitations SOLUTIONS MANUAL Discussion Questions (1) [LO1] The goal of tax planning is to minimize taxes. Explain why this statement is not true. In general terms, the goal of tax planning is to maximize the taxpayers aftertax wealth while simultaneously achieving the taxpayers nontax goals. Maximizing after-tax wealth is not necessarily the same as tax minimization. Specifically, maximizing after-tax wealth requires one to consider both the tax and nontax costs and benefits of alternative transactions, whereas tax minimization focuses solely on a single cost (i.e., taxes). (2) [LO1] Describe the three parties engaged in every business transaction and how understanding taxes may aid in structuring transactions. There are three parties involved in virtually every transaction: the taxpayer, the other transacting party, and the government (i.e., the uninvited silent party that specifies the tax consequences of the transaction). Effective tax planning requires an understanding of the tax and nontax costs from the taxpayers and other partys perspectives because tax and nontax factors also influence the other partys preferences. Understanding these preferences will allow the taxpayer to identify an optimal transaction structure. (3) [LO1] In this chapter we discussed three basic tax planning strategies. What different features of taxation does each of these strategies exploit? The timing strategy exploits the variation in taxation across time i.e., the real tax costs of income decrease as taxation is deferred; the real tax savings associated with tax deductions increase as tax deductions are accelerated. The income shifting strategy exploits the variation in taxation across taxpayers. Finally, the conversion strategy exploits the variation in taxation across activities. (4) [LO2] What are the two basic timing strategies? What is the intent of each? The two strategies are deferring taxable income and accelerating tax deductions. The intent of deferring taxable income recognition is to minimize the present value of taxes paid. The intent of accelerating tax deductions is to maximize the present value of tax savings from the deductions. 3-1 Chapter 3 - Tax Planning Strategies and Related Limitations 2 Chapter 3 - Tax Planning Strategies and Related Limitations (5) [LO2] Why is the timing strategy particularly effective for cash-method taxpayers? The timing strategy is particularly effective for cash-method taxpayers because the deduction year for cash-method taxpayers depends on when the taxpayer pays the expense (which the taxpayer controls). (6) [LO2] What are some common examples of the timing strategy? The timing strategy is an important aspect of investment planning, retirement planning, and property transactions It is also an important aspect of tax planning for everyday business operations (e.g., determining the appropriate period to recognize sales income upon product shipment, delivery, or customer acceptance). Some common examples of the timing strategy include accelerating depreciation deductions for depreciable assets, using LIFO versus FIFO for inventory, accelerating the deduction of certain prepaid expenses, etc. (7) [LO2] What factors increase the benefits of accelerating deductions or deferring income? Higher tax rates, higher interest rates, larger transaction amounts, and the ability to accelerate deductions by two or more years increase the benefits of accelerating deductions. Likewise, higher tax rates, higher interest rates, larger transaction amounts, and the ability to defer revenue recognition for longer periods of time increase the benefits of income deferral. (8) [LO2,LO3] How do changing tax rates affect the timing strategy? What information do you need to determine the appropriate timing strategy when tax rates change? When tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions will now vary. The higher the tax rate, the higher the tax savings for a tax deduction. The lower the tax rate, the lower the tax costs for taxable income. All things being equal, taxpayers should prefer to recognize deductions during high-tax-rate years and income during low-tax-rate years. The implication is that before a taxpayer implements the timing strategies (accelerate deductions, defer income), she should consider whether her tax rates are likely to change. Increasing tax rates may actually result in taxpayers preferring to accelerate income and defer deductions. To determine the appropriate timing strategy when tax rates change, you need the taxpayers after-tax rate of return and the amount of the tax rate increase. 3-3 Chapter 3 - Tax Planning Strategies and Related Limitations (9) [LO2,LO6] Describe the ways in which the timing strategy has limitations. Timing strategies contain several inherent limitations. Generally speaking, whenever a taxpayer is unable to accelerate a deduction without also accelerating the cash outflow, the timing strategy will be less beneficial. Tax law generally requires taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes. A deferral strategy may not be optimal if the taxpayer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unnecessary risk, etc. The constructive receipt doctrine, which provides that a taxpayer must recognize income when it is actually or constructively received, also restricts income deferral for cash-method taxpayers. (10) [LO3] The concept of the time value of money suggests that $1 today is not equal to $1 in the future. Explain why this is true. Assuming an investor can earn a positive return (e.g., 5 percent), $1 invested today should be worth $1.05 ($1 x (1+.05)1 in one year. Hence, $1 today is equivalent to $1.05 in one year. (11) [LO3] Why is understanding the time value of money important for tax planning? Taxes paid are cash outflows, and tax savings generated from tax deductions can be thought of as cash inflows. With this perspective, the timing of when a taxpayer pays tax on income or receives a tax deduction for an expenditure obviously affects the present value of the taxes paid (i.e., a cash outflow) or tax savings received (i.e., a cash inflow). (12) [LO3] What two factors increase the difference between present and future values? The rate of return and the investment period. (13) [LO4] What factors have to be present for income shifting to be a viable strategy? Income shifting requires (1) a legitimate method of shifting income that will withstand IRS scrutiny and (2) either (a) related parties, such as family members or businesses and their owners, who have varying marginal tax rates and are willing to shift income for the benefit of the group or (b) taxpayers operating in multiple jurisdictions with different marginal tax rates. 4 Chapter 3 - Tax Planning Strategies and Related Limitations (14) [LO4] Name three common types of income shifting. Income shifting from high tax rate parents to low tax rate children; income shifting from businesses to their owners; taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions. (15) [LO4] What are some ways that a parent could effectively shift income to a child? What are some of the disadvantages of these methods? Parents who own a business may shift income to their children by employing them to work for the business. Because this is a related-party transaction, it is important for the substance of the transaction to be justifiable, not just the form of the transaction. One disadvantage of this method is that it requires the children to actually perform services for the parents business, which may or may not be a positive factor given the skill set of the children and the ability of the family to work together in harmony. Parents may also shift investment income to their children by transferring the underlying investments to the children. The disadvantages of this strategy are somewhat obviousmany parents may not be able to afford to transfer significant wealth to their children or would have serious reservations about doing so. The kiddie tax may also apply when parents shift too much investment income to children. The kiddie tax restricts the amount of a childs investment income that can be taxed at the childs (lower) tax rate instead of the parents (higher) tax rate. (16) [LO4] What is the key factor in shifting income from a business to its owners? What are some methods of shifting income in this context? To shift income from the corporation to the owner, the transaction must generate a tax deduction to the corporation. Compensation paid to employee-owners is the most common method of shifting income from corporations to their owners. Compensation expense is deductible by the corporation and is generally taxable to the employee. Having the business owner rent property to the corporation or loan money to the corporation are also effective income shifting methods, because both transactions generate tax deductions for the corporation and income for the shareholder. Because corporations do not get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Instead, paying dividends results in double taxationthe profits generating the dividends are taxed first at the corporate level, and then the dividends are taxed at the shareholder level. (17) [LO4] Explain why paying dividends is not an effective way to shift income from a corporation to its owners. 3-5 Chapter 3 - Tax Planning Strategies and Related Limitations Because corporations do not get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Instead, paying dividends results in double taxationthe profits generating the dividends are taxed first at the corporate level, and then the dividends are taxed at the shareholder level. (18) [LO5] What are some of the common examples of the conversion strategy? In Chapter 11, we consider investment planning and the advantages of investing in assets that generate preferentially taxed income. In Chapter 8, we explain the basic differences between business and investment activities and what characteristics result in the more favorable business designation for expense deductions. In Chapters 12 and 13, we discuss compensation planning and the benefits of restructuring employee compensation from currently taxable compensation to nontaxable or tax deferred forms of compensation, such as employer-provided health insurance and retirement contributions. (19) [LO5] What is needed to implement the conversion strategy? To implement the conversion strategy, one must be aware of the underlying 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. (20) [LO5] Explain how implicit taxes may limit the benefits of the conversion strategy. The concept of implicit taxes suggests that the demand for tax advantaged activities increases the costs associated with these activities, thereby reducing the pretax returns of these activities and the advantages of the conversion strategy. For example, implicit taxes may reduce or eliminate the advantages of tax-preferred investments (e.g., municipal bonds, or investments taxed at preferential tax rates) by decreasing the pretax rate of returns for these investments. (21) [LO6] Several judicial doctrines limit basic tax planning strategies. What are they? Which planning strategies do they limit? The constructive receipt doctrine, which provides that a taxpayer must recognize income when it is actually or constructively received, restricts income deferral for cash-method taxpayers (i.e., the timing strategy). 6 Chapter 3 - Tax Planning Strategies and Related Limitations The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns the income. The assignment of income doctrine implies that, in order to shift income to a taxpayer (i.e., the income shifting strategy), that taxpayer must actually earn the income. The business purpose doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation. The step-transaction doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction. Finally, the substance-over-form doctrine allows the IRS to consider the transactions substance regardless of its form, and where appropriate, reclassify the transaction according to its substance. The IRS uses each of these doctrines where they expect taxpayer abuse. They can be used to void income shifting, conversion, and timing strategies. (22) [LO6] What is the constructive receipt doctrine? What types of taxpayers does this doctrine generally affect? For what tax planning strategy is the constructive receipt doctrine a potential limitation? The constructive receipt doctrine limits income deferral (i.e., the timing strategy) for cash-method taxpayers. Unlike accrual-method taxpayers, cash-method taxpayers report income for tax purposes when the income is received (in the form of cash, property, services, etc.). The cash method affords taxpayers some leeway in timing when to recognize income because, to some extent, taxpayers can control when they receive income (e.g., by accelerating or deferring billing their clients). The constructive receipt doctrine provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayers account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the incomes availability, and there are no restrictions on the taxpayers control over the income. (23) [LO6] Explain the assignment of income doctrine. In what situations would this doctrine potentially apply? The assignment of income doctrine requires income to be taxed to the taxpayer that actually earns the income. Merely assigning income (e.g., someones paycheck or dividend) to another taxpayer does not transfer the tax liability associated with the income. The implication of the assignment of income doctrine is that to shift income to a taxpayer (i.e., to employ the shifting strategy), the taxpayer must actually earn the income. 3-7 Chapter 3 - Tax Planning Strategies and Related Limitations (24) [LO6] Relative to arms-length transactions, why do related-party transactions receive more IRS scrutiny? In arms-length transactions, each transacting party negotiates for his or her own benefit. In contrast, taxpayers engaged in related-party transactions are much more willing to negotiate for the common good of the related parties and to the detriment of the IRS. Accordingly, the IRS pays special attention to related party transactions. (25) [LO6] Describe the business purpose, step-transaction, and substance-over-form doctrines. What types of tax planning strategies may these doctrines inhibit? The business purpose doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation. The step-transaction doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction. Finally, the substance-over-form doctrine allows the IRS to consider the transactions substance regardless of its form, and where appropriate, reclassify the transaction according to its substance. The IRS uses these doctrines where they expect taxpayer abuse. They can be used to void income shifting, conversion, and timing strategies. (26) [LO7] What is the difference between tax avoidance and tax evasion? Tax avoidance is the legal act of arranging ones affairs to minimize taxation. It has long been endorsed by the courts and Congress. In contrast to tax avoidance, tax evasion (willful intent to defraud the government) falls outside the confines of legal tax avoidance. In many cases there is a clear distinction between avoidance (e.g., not paying tax on municipal bond interest) and evasion (e.g., not paying tax on $1,000,000 game show prize). In other cases, the line between tax avoidance and evasion is less clear. In these situations, professional judgment, the use of a smell test, and consideration of the business purpose, step transaction, and substance-over-form doctrines may prove useful. (27) [LO7] What are the rewards of tax avoidance? What are the rewards of tax evasion? The rewards of tax avoidance include maximizing the taxpayers wealth. The rewards of tax evasion include civil and criminal penalties, including large monetary fines and sentencing to federal prison. (28) [LO7] Tax avoidance is discouraged by the courts and Congress. Is this statement true or false? Please explain. 8 Chapter 3 - Tax Planning Strategies and Related Limitations False. The courts have often made it quite clear that taxpayers are under no obligation to pay more taxes than required by law. As an example, in Commissioner v. Newman, 159 F.2d 848 (2 Cir., 1947), which considered a taxpayers ability to shift income to his children using trusts, Judge Learned Hand included the following statement in his dissenting opinion. 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. Problems (29) [LO2 PLANNING] Yong recently paid his accountant $10,000 for elaborate tax planning strategies that exploit the timing strategy. Assuming this is an election year and there could be a power shift in the White House and Congress, what is a potential risk associated with Yongs strategies? Changes in the control of the White House and Congress may result in a fundamental shift in tax policy. Tax rate changes are rather frequent as lawmakers use them as an integral part of fiscal or economic policy initiatives (e.g., to raise revenue, stimulate the economy, etc.). The risk to Yong is that the newly elected officials will change the tax system in a way that eliminates the benefits of his tax planning strategies (e.g., increasing tax rates in the future may reduce or eliminate the benefits of income deferral). (30) [LO2, LO3 PLANNING] Billups, a physician and cash-method taxpayer, is new to the concept of tax planning and recently learned of the timing strategy. To implement the timing strategy, Billups plans to establish a new policy that allows all his clients to wait two years to pay their co-pays. Assume that Billups does not expect his marginal tax rates to change. What is wrong with his strategy? While this plan defers the taxation on the co-pays, it also delays Billups receipt of the co-pays. Assuming that Billups doesnt charge his clients any interest on their delayed payment, this plan will reduce the present value of taxes paid on the co-pays and the present value of the co-pays. The decrease in the present value of the co-pays will exceed the decrease in the present value of the tax paid on the co-pays (not a good thing). In addition, by delaying payment, Billups may increase the likelihood that many of his clients will not pay their co-pays. In summary, this is not a good plan. 3-9 Chapter 3 - Tax Planning Strategies and Related Limitations (31) [LO2, LO3 PLANNING] Tesha works for a company that pays a year-end bonus in January of each year (instead of December of the preceding year) to allow employees to defer the bonus income. Assume Congress recently passed tax legislation that decreases individual tax rates as of next year. Does this increase or decrease the benefits of the bonus deferral this year? What if Congress passed legislation that increased tax rates next year? Should Tesha ask the company to change its policy this year? What additional information do you need to answer this question? The decrease in the tax rates increases the benefits of the bonus deferral. If Congress instead passed a tax rate increase, the benefit of deferral may be reduced or eliminated. To determine if Tesha should request the company to change its policy this year (i.e., to pay bonuses in December), you need to know the amount of the tax rate increase and Teshas after-tax rate of return. (32) [LO2, LO3 PLANNING] Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 40 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 billthis year or next? Option 1: Pay $20,000 bill in December: $20,000 tax deduction x 40 percent marginal tax rate = $8,000 in present value tax savings. After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $8,000 = $12,000 Option 2: Pay $20,000 bill in January: $20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax savings in one year. Present Value of Tax Savings = $8,000 x .893 (Discount Factor, 1 Year, 12 percent) = $7,144 After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $7,144 = $12,856 10 Chapter 3 - Tax Planning Strategies and Related Limitations Paying the $20,000 in December is the clear winner. (33) [LO2, LO3 PLANNING] Using the facts from the previous problem, how would your answer change if Isabels after-tax rate of return were 8 percent? Option 1: Pay $20,000 bill in December: $20,000 tax deduction x 40 percent marginal tax rate = $8,000 in present value tax savings. After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $8,000 = $12,000 Option 2: Pay $20,000 bill in January: $20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax savings in one year. Present Value of Tax Savings = $8,000 x .926 (Discount Factor, 1 Year, 8 percent) = $7,408 After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $7,408 = $12,592 Paying the $20,000 in December is the clear winner. (34) [LO2,LO3 PLANNING] Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $20,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Mannys marginal tax rate is 40 percent this year and next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Manny send his client the bill in December or January? Option 1: Send $20,000 bill in December: $20,000 taxable income x 40 percent marginal tax rate = $8,000 in present value tax After-tax income = Pretax income Present Value Tax = $20,000 $8,000 = $12,000 3-11 Chapter 3 - Tax Planning Strategies and Related Limitations Option 2: Send $20,000 bill in January: $20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one year. Present Value of Tax = $8,000 x .893 (Discount Factor, 1 Year, 12 percent) = $7,144 After-tax income = Pretax income Present Value Tax = $20,000 $7,144 = $12,856 Sending the $20,000 bill in January is the clear winner. (35) [LO2,LO3 PLANNING] Using the facts from the previous problem, how would your answer change if Mannys after-tax rate of return were 8 percent? Option 1: Send $20,000 bill in December: $20,000 taxable income x 40 percent marginal tax rate = $8,000 in present value tax After-tax income = Pretax income Present Value $20,000 Tax = $8,000 = $12,000 Option 2: Send $20,000 bill in January: $20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one year. Present Value of Tax = $8,000 x .926 (Discount Factor, 1 Year, 8 percent) = $7,408 After-tax income = Pretax income Present Value Tax = $20,000 $7,408 = $12,592 Sending the $20,000 bill in January is the clear winner. 12 Chapter 3 - Tax Planning Strategies and Related Limitations (36) [LO2, LO3 PLANNING] Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Reese can pay the $20,000 bill any time before January 30 of next year without penalty. Assume Reeses marginal tax rate is 30 percent this year and will be 40 percent next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 billthis year or next? Option 1: Pay $20,000 bill in December: $20,000 tax deduction x 30 percent marginal tax rate = $6,000 in present value tax savings. After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $6,000 = $14,000 Option 2: Pay $20,000 bill in January: $20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax savings in one year. Present Value of Tax Savings = $8,000 x .893 (Discount Factor, 1 Year, 12 percent) = $7,144 After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $7,144 = $12,856 Paying the $20,000 in January is the clear winner. (37) [LO2, LO3 PLANNING] Using the facts from the previous problem, when should Reese pay the bill if she expects her marginal tax rate to be 33 percent next year? 25 percent next year? If the tax rate next year is 33 percent instead of 40 percent, Option 2 changes as follows: Option 2: Pay $20,000 bill in January: $20,000 tax deduction x 33 percent marginal tax rate = $6,600 in tax savings in one year. 3-13 Chapter 3 - Tax Planning Strategies and Related Limitations Present Value of Tax Savings = $6,600 x .893 (Discount Factor, 1 Year, 12 percent) = $5,893.80 After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $5,893.80 = $14,106.20 Paying the $20,000 in December would be preferred. If the tax rate next year is 25 percent instead of 40 percent, Option 2 changes as follows: Option 2: Pay $20,000 bill in January: $20,000 tax deduction x 25 percent marginal tax rate = $5,000 in tax savings in one year. Present Value of Tax Savings = $5,000 x .893 (Discount Factor, 1 Year, 12 percent) = $4,465.00 After-tax cost = Pretax Cost Present Value Tax Savings = $20,000 $4,465.00 = $15,535.00 Paying the $20,000 in December would be preferred. (38) [LO2, LO3 PLANNING] Hank, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $20,000 of legal services for a client. Hank typically requires his clients to pay his bills immediately upon receipt. Assume his marginal tax rate is 30 percent this year and will be 40 percent next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Hank send his client the bill in December or January? Option 1: Send the $20,000 bill in December: $20,000 taxable income x 30 percent marginal tax rate = $6,000 in present value tax After-tax income = Pretax income Present Value Tax = $20,000 $6,000 = $14,000 14 Chapter 3 - Tax Planning Strategies and Related Limitations Option 2: Send the $20,000 bill in January: $20,000 taxable income x 40 percent marginal tax rate = $8,000 in tax in one year. Present Value of Tax = $8,000 x .893 (Discount Factor, 1 Year, 12 percent) = $7,144 After-tax income = Pretax income Present Value Tax = $20,000 $7,144 = $12,856 Sending the $20,000 bill in December is the clear winner. (39) [LO2, LO3 PLANNING] Using the facts from the previous problem, when should Hank send the bill if he expect his marginal tax rate to be 33 percent next year? 25 percent next year? If the tax rate next year is 33 percent instead of 40 percent, Option 2 changes as follows: Option 2: Send the $20,000 bill in January: $20,000 taxable income x 33 percent marginal tax rate = $6,600 in tax in one year. Present Value of Tax = $6,600 x .893 (Discount Factor, 1 Year, 12 percent) = $5,893.80 After-tax income = Pretax income Present Value Tax = $20,000 $5,893.80 = $14,106.20 Sending the $20,000 bill in January would be preferred. If the tax rate next year is 25 percent instead of 40 percent, Option 2 changes as follows: Option 2: Send the $20,000 bill in January: $20,000 taxable income x 25 percent marginal tax rate = $5,000 in tax in one year. Present Value of Tax = $5,000 x .893 (Discount Factor, 1 Year, 12 percent) = $4,465.00 3-15 Chapter 3 - Tax Planning Strategies and Related Limitations After-tax income = Pretax income Present Value Tax = $20,000 $4,465.00 = $15,535.00 Sending the $20,000 bill in January would be preferred. (40) [LO3] Geraldo recently won a lottery and chose to receive $100,000 today instead of an equivalent amount in ten years, computed using an 8 percent rate of return. Today, he learned that interest rates are expected to increase in the future. Is this good news for Geraldo given his decision? This is good news for Geraldos decision. If Geraldo chose to defer the $100,000 at an 8 percent interest rate, the increase in interest rates would have reduced the present value of the lottery winnings. The equivalent amount in 10 years at 8 percent is approximately $216,00. If this amount was discounted back to present value at 10 percent (instead of 8 percent), the present value would be only about $83,000. (41) [LO3 PLANNING] Assume Rafael can earn an 8 percent after-tax rate of return. Would he prefer $1,000 today or $1,500 in five years? $1,500 in five years is worth $1,021.50 today ($1,500 x .681 (Discount Factor, 5 Year, 8 percent)). Thus, $1,500 (worth $1,021.50 today) in five years should be preferred over $1,000 today. (42) [LO3 PLANNING] Assume Ellina earns a 10 percent after-tax rate of return, and that she owes a friend $1,200. Would she prefer to pay the friend $1,200 today or $1,750 in four years? $1,750 in four years in worth $1,195.25 today ($1,750 x .683 (Discount Factor, 4 Year, 10 percent)). Thus, paying $1,750 (worth $1,195.25 today) in four years should be preferred over $1,200 today. (43) [LO3 PLANNING] Jonah has the choice of paying Rita $10,000 today or $40,000 in ten years. Assume Jonah can earn a 12 percent after-tax rate of return. Which should he choose? $40,000 in ten years is worth $12,880 today ($40,000 x .322 (Discount Factor, 10 Year, 12 percent)). Thus, paying $10,000 today should be preferred over paying $40,000 (worth $12,880 today) in ten years. 16 Chapter 3 - Tax Planning Strategies and Related Limitations (44) [LO3 PLANNING] Bobs Lottery, Inc., has decided to offer winners a choice of $100,000 in ten years or some amount currently. Assume that Bobs Lottery, Inc., earns a 10 percent after-tax rate of return. What amount should Bob offer lottery winners currently, in order for him to be indifferent between the two choices? $100,000 in ten years is worth $38,600 today to Bob ($100,000 x .386 (Discount Factor, 10 Year, 10 percent)). Thus, Bob should offer lottery winners $38,600 today for him to be indifferent between the two choices. (45) [LO4 PLANNING] Tawana owns and operates a sole proprietorship and has a 40 percent marginal tax rate. She provides her son, Jonathon, $8,000 a year for college expenses. Jonathon works as a pizza delivery person every fall and has a marginal tax rate of 15 percent. a. What could Tawana do to reduce her family tax burden? b. How much pretax income does it currently take Tawana to generate the $8,000 after-taxes given to Jonathon? c. If Jonathon worked for his mothers sole proprietorship, what salary would she have to pay him to generate $8,000 after taxes (ignoring any Social Security, Medicare, or self-employment tax issues)? d. How much money would this strategy save? a. Tawana could reduce her familys tax burden by employing her son in her sole proprietorship, thus shifting income taxed at 40 percent (Tawanas marginal tax rate) to 15 percent (Jonathons tax rate). b. It currently takes Tawana $13,333 of pretax income to generate the $8,000 after-taxes given to Jonathon. After-tax income = Pretax income x (1 marginal tax rate) $8,000 = Pretax income x (1 .40) Pretax income = $8,000 / (.60) = $13,333. c. If Jonathon worked for Tawanas sole proprietorship, she would only have to pay him $9,412 to generate $8,000 after-taxes. After-tax income = Pretax income x (1 marginal tax rate) $8,000 = Pretax income x (1 .15) Pretax income = $8,000 / (.85) = $9,412. 3-17 Chapter 3 - Tax Planning Strategies and Related Limitations d. This strategy will save Tawanna $3,921 pretax (i.e., $13,333 $9,412). The analysis of the after-tax savings from this strategy is as follows: Tawana pays her son ($9,412). This saves Tawana $3,765 in taxes because the payment is deductible ($9,412 x 40%). Her son receives $9,412. This costs her son ($1,412) in taxes because he must pay tax on the compensation ($9,412 x 15%). Total savings is $2,353 ($3,765 - $1,412). The after tax savings are the result of shifting $9,412 of income from Tawana to her son. Consequently, the family unit is paying taxes on the $9,412 at 15% instead of 40%. $9,412 x (40% -15%) = $2,353 after tax savings. (46) [LO4 PLANNING] Moana is a single taxpayer who operates a sole proprietorship. She expects her taxable income next year to be $250,000, of which $200,000 is attributed to her sole proprietorship. Moana is contemplating incorporating her sole proprietorship. Using the single individual tax brackets and the corporate tax brackets, find out how much current tax this strategy could save Moana (ignore any Social Security, Medicare, or self-employment tax issues). How much income should be left in the corporation? Assuming Moanas goal is to minimize her current federal income tax exposure, one can compare the single individual and corporate tax rate schedules to achieve this goal. Since Moana has $50,000 of taxable income not related to her sole proprietorship, she is currently in the 25 percent tax bracket. The task is to allocate the $200,000 between Moana and her corporation to minimize her current liability. The lowest corporate tax rate is 15 percent (taxable income from 0 to $50,000) and is lower than Moanas marginal tax rate of 25 percent. To take advantage of the 15 percent corporate tax bracket, $50,000 of the expected $200,000 in profits should be retained in the corporation. [$50,000 is the width of the 15 percent corporate tax bracket.] Assuming the corporation retains $50,000 of profit, the corporations marginal tax rate would now be 25 percent and thus, Moanas choice is to have income taxed at 25 percent (the corporations marginal tax rate) or 25 percent (Moanas marginal tax rate). Lets assume that, all things equal, Moana prefers to receive the profits personally. To take advantage of Moanas 25 percent personal tax bracket, the next $35,650 of the expected $200,000 in profits should be shifted to Moana. [$35,650 is the remaining width of Moanas 25 percent tax bracket]. Moanas marginal tax rate would now be 28 percent. Continuing this same decision process, $25,000 of the remaining $114,350 of profits should be retained by the corporation, and the rest ($89,350) should be shifted to Moana. In summary, $75,000 of the 18 Chapter 3 - Tax Planning Strategies and Related Limitations expected profits are retained in the corporation and $125,000 of the profits are shifted to Moana. 3-19 Chapter 3 - Tax Planning Strategies and Related Limitations This strategy will save Moana $10,817 calculated as: (a) The tax on $250,000 of taxable income reported by Moana assuming that she operates her business as a sole proprietorship. Less: (b) The tax on $175,000 of taxable income reported by Moana assuming that she incorporates her business $67,028 $42,461 and (c) the tax on $75,000 profits retained in the corporation $13,750 = $10,817 (47) [LO4 PLANNING] Orie and Jane, husband and wife, operate a sole proprietorship. They expect their taxable income next year to be $275,000, of which $125,000 is attributed to the sole proprietorship. Orie and Jane are contemplating incorporating their sole proprietorship. Using the married-joint tax brackets and the corporate tax brackets, find out how much current tax this strategy could save Orie and Jane. How much income should be left in the corporation? Assuming Orie and Janes goal is to minimize their current federal income tax exposure, one can compare the married filing joint and corporate tax rate schedules to achieve this goal. Since Orie and Jane have $150,000 of taxable income not related to their sole proprietorship, they are currently in the 28 percent tax bracket. The task is to allocate the $125,000 between Orie and Jane and their corporation to minimize their current liability. The lowest corporate tax rate is 15 percent (taxable income from 0 to $50,000) and is lower than Orie and Janes marginal tax rate of 28 percent. To take advantage of the 15 percent corporate tax bracket, $50,000 of the expected $125,000 in profits should be retained in the corporation. [$50,000 is the width of the 15 percent corporate tax bracket.] Assuming the corporation retains $50,000 of profit, the corporations marginal tax rate would now be 25 percent and thus, Orie and Janes choice is to have income taxed at 25 percent (the corporations marginal tax rate) or 28 percent (Orie and Janes marginal tax rate). 25 percent is the obvious choice. To take advantage of the corporations 25 percent tax bracket, the next $25,000 of the expected $125,000 in profits should be retained in the corporation. [$25,000 is the width of the 25 percent corporate tax bracket]. The corporations marginal tax rate would now be 34 percent. Continuing this same decision process, the remaining $50,000 of profits should be shifted to Orie and Jane. In summary, $75,000 of the expected profits are retained in the corporation and $50,000 of the profits are shifted to Orie and Jane. 20 Chapter 3 - Tax Planning Strategies and Related Limitations This strategy will save Orie and Jane $10,127.50 calculated as: (a) The tax on $275,000 of taxable income reported by Orie and Jane assuming that they operate their business as a sole proprietorship. $67,656.50 Less: (b) The tax on $200,000 of taxable income reported by Orie and Jane assuming that they incorporate the business $43,779.00 and (c) the tax on $75,000 profits retained in the corporation $13,750.00 = $10,127.50 (48) [LO4 PLANNING] Hyundai is considering opening a plant in two neighboring states. One state has a corporate tax rate of 10 percent. If operated in this state, the plant is expected to generate $1,000,000 pretax profit. The other state has a corporate tax rate of 2 percent. If operated in this state, the plant is expected to generate $930,000 of pretax profit. Which state should Hyundai choose? Why do you think the plant in the state with a lower tax rate would produce a lower before-tax income? Hyundai should choose to operate the plant in the state with the 2 percent tax rate. Operating the plant in this state would generate $911,400 of profits after state taxes (i.e., $930,000 (2 percent x $930,000) = $911,400)) versus $900,000 of profits after state taxes (i.e., $1,000,000 (10 percent x $1,000,000) = $900,000) in the state with the 10 percent tax rate. The state with a lower tax rate produces a lower pretax income because the demand for workers, services, property, etc. in the low-tax rate state jurisdictions has most likely increased the costs associated with operating a business in this state. These increased costs are considered implicit taxes and reduce the tax advantages of operating in the low tax rate state. (49) [LO4, LO6 PLANNING] Bendetta, a high-tax-rate taxpayer, owns several rental properties and would like to shift some income to her daughter, Jenine. Bendetta instructs her tenants to send their rent checks to Jenine so Jenine can report the rental income. Will this shift the income from Bendetta to Jenine? Why or why not? 3-21 Chapter 3 - Tax Planning Strategies and Related Limitations Merely sending the checks to Jenine is not sufficient to shift the rental income from Bendetta to Jenine under the assignment of income doctrine. To shift the rental income to Jenine, she must earn the income. In this case, this means that Jenine must actually own the rental property to report the rental income. (50) [LO4, LO6 PLANNING] Using the facts in the previous problem, what are some ways that Bendetta could shift some of the rental income to Jenine? What are the disadvantages associated with these income-shifting strategies? Bendetta could employ her daughter to work for the rental business, and thus, shift income via compensation paid to Jenine. The disadvantage of this strategy is that Jenine must actually perform services for the rental business, and the compensation must be reasonable (which limits the amount of income that can be shifted). Alternatively, Bendetta could transfer ownership of the rental properties to Jenine (e.g., via gift). The disadvantage of this strategy is that most taxpayers would prefer to maintain their wealth and may have serious reservations about transferring significant wealth to their children. (51) [LO5 PLANNING] Daniel is considering selling two stocks that have not fared well over recent years. A friend recently informed Daniel that one of his stocks has a special designation, which allows him to treat a loss up to $50,000 on this stock as an ordinary loss rather than the typical capital loss. Daniel figures that he has a loss of $60,000 on each stock. If Daniels marginal tax rate is 35 percent and he has $120,000 of other capital gains (taxed at 15 percent), what is the tax savings from the special tax treatment? If Daniel sells both stocks, he will generate tax savings as follows: Special Normal Explanation stock stock (1) Loss ($60,000) ($60,000) Given in problem (2) Ordinary tax 17,500 n/a $50,000 limit x 35% MTR savings (3) Capital loss tax 1,500 9,000 Special stock: $10,000 savings remaining loss x 15% capital rate Normal stock: $60,000 x 15% capital rate (4) Total tax savings $19,000 $9,000 Sum of (2) and (3) Additional savings on $10,000 Difference in (4) between special stock special stock and normal stock. 22 Chapter 3 - Tax Planning Strategies and Related Limitations (52) [LO5 PLANNING] Dennis is currently considering investing in municipal bonds that earn 6 percent interest, or in taxable bonds issued by the Coca-Cola Company that pay 8 percent. If Dennis tax rate is 20 percent, which bond should he choose? Which bond should he choose if his tax rate is 30 percent? At what tax rate would he be indifferent between the bonds? What strategy is this decision based upon? Dennis after-tax rate of return on the tax exempt bond is 6 percent (i.e., the same as its pretax rate of return). The Coca-Cola Company bond pays taxable interest of 8 percent. Dennis after-tax rate of return on the CocaCola Company bond is 6.4 percent (i.e., 8 percent interest income (8 percent x 20 percent) tax = 6.4 percent). Dennis should invest in the CocaCola Company bond. If Dennis marginal tax rate is 30 percent, his after-tax rate of return on the Coca-Cola Company bond would be 5.6 percent (i.e., 8 percent interest income (8 percent x 30 percent) tax = 5.6 percent). Dennis should invest in the tax exempt bond in this situation. Dennis would be indifferent between the two bonds if his marginal tax rate is 25 percent. After-tax return = Pretax return x (1 marginal tax rate) 6 percent = 8 percent x (1 marginal tax rate) = 8 percent (8 percent x marginal tax rate) 8 percent marginal tax rate = 2 percent marginal tax rate = 2 percent / 8 percent = 25 percent This example is an illustration of the conversion planning strategy. (53) [LO5 PLANNING] Helen holds 1,000 shares of Fizbo Inc. stock that she purchased 11 months ago. The stock has done very well and has appreciated $20/share since Helen bought the stock. When sold, the stock will be taxed at capital gains rates (long-term rate is 15% and short-term rate is the taxpayers marginal tax rate). If Helens marginal tax rate is 35%, how much would she save by holding the stock an additional month before selling? What might prevent Helen from waiting to sell? 3-23 Chapter 3 - Tax Planning Strategies and Related Limitations The gain on the sale of the stock would be $20,000 (1,000 shares x $20/share appreciation). If she waits, she will pay a tax of $3,000 ($20,000 x 15%); whereas if she sells immediately, she will pay a tax of $7,000 ($20,000 x 35%). Her tax savings from waiting the additional month would be $4,000 ($7,000 $3,000). Helen bears additional risk if she holds the stock for an additional month. The stock price could decrease substantially if there is market volatility or if the company encounters financial difficulties. In addition, Helen may be selling the stock to generate cash flow for which she may be unwilling to wait. (54) [LO7] Duff is really interested in decreasing his tax liability, and by his very nature he is somewhat aggressive. A friend of a friend told him that cash transactions are more difficult for the IRS to identify and, thus, tax. Duff is contemplating using this strategy of not reporting cash collected in his business to minimize his tax liability. Is this tax planning? What are the risks with this strategy? This is not tax planning. Instead, this strategy is tax evasion. The rewards of tax evasion include stiff monetary penalties and imprisonment. (55) [LO7] Using the facts from the previous problem, how would your answer change if instead, Duff adopted the cash method of accounting to allow him to better control the timing of his cash receipts and disbursements? This strategy would fall within the confines of legitimate tax planning, and thus, Duff should not be subject to the potential risks associated with tax evasion. (56) [LO2, LO4, LO5 PLANNING, RESEARCH] Using an available tax service or the Internet, identify three basic tax planning ideas or tax tips suggested for yearend tax planning. Which basic tax strategy from this chapter does each planning idea employ? The answers to this question will vary by student but should incorporate the basic strategies of timing, income shifting, and conversion. (57) [LO7 RESEARCH] Jayanna, an advertising consultant, is contemplating instructing some of her clients to pay her in cash so that she does not have to report the income on her tax return. Use an available tax service to identify the three basic elements of tax evasion and penalties associated with tax evasion. Write a memo to Jayanna explaining tax evasion and the risks associated with her actions. 24 Chapter 3 - Tax Planning Strategies and Related Limitations IRC Sec. 7201 states that tax evasion is a felony punishable by a fine of not more than $100,000 ($500,000 in the case of a corporation), or five years' imprisonment, or both. The three elements to the crime of tax evasion are (1) willfulness, (2) an attempt to evade tax, and (3) additional tax due. Jayannas actions would satisfy each element. There are numerous court cases that describe these three elements and any tax service can be used to locate relevant cases. For example, see U.S. v. Friedberg, David, (1953, CA6) 44 AFTR 549, 207 F2d 777, 53-2 USTC 9632, affd (1954, S Ct) 46 AFTR 954, 348 US 142, 99 L Ed 188, 54-2 USTC 9713, reh den (1955, S Ct) 46 AFTR 1361, 348 US 932, 99 L Ed 731. (58) [LO7 RESEARCH] Using the IRS Web site (www.irs.gov/index.html), how large is the current estimated tax gap (i.e., the amount of tax underpaid by taxpayers annually)? What group of taxpayers represents the largest contributors to the tax gap? The estimated tax gap is approximately $350 billion, most of which is attributable to underreporting of income by individual taxpayers. 3-25 ... View Full Document