Chapter 4 - Maxims of Income Tax Planning

What is tax avoidance?

Legitimate means of reducing taxes

What is tax evasion?

Illegal means of reducing taxes

What are the 4 Tax Planning Variables?

1. Entity Variable

2. Time Period Variable

3. Jurisdiction Variable

4. Character Variable

What question does the entity variable ask?

Which entity undertakes the transaction?

What question does the time period variable ask?

During which tax year does the transaction occur?

What question does the jurisdiction variable ask?

In which tax jurisdiction does the transaction occur?

What question does the character variable ask?

What is the tax character of the income, gain, loss, or deduction from the transaction?

What are the two taxpaying business entities?

Individuals and Corporations

What is the tax rate structure for individual taxpayers income tax?

Progressive tax rate structure ranging from 10% to 37%

What is the tax rate structure for corporate taxpayers income tax?

Proportionate tax rate of 21%

What is Tax Planning Maxim 1 (Entity)?

Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate

What is income shifting?

Arranging transactions to transfer income from a high tax rate entity to a low tax rate entity

What is deduction shifting?

Arranging transactions to transfer deductions from a low tax rate entity to a high tax rate entity

What are the 2 constraints to income shifting under the Assignment of Income Doctrine?

1. Income must be taxed to the entity that earns it from the sale of goods or performance of services

2. Income generated by capital must be taxed to the entity that owns the capital

What is Tax Planning Maxim 2 (Time Period)?

In present value terms, tax costs decrease (and cash flows increase) when a tax cost is deferred until a later taxable year

What is Tax Planning Maxim 2 (Time Period) constrained by (2)?

1. Opportunity Costs

2. Tax Rate Increases

How is Tax Planning Maxim 2 (Time Period) constrained by opportunity costs?

Shifting tax costs to a later period may involve postponing a cash inflow

The opportunity cost of postponing the cash inflow may exceed the savings from tax deferral

How is Tax Planning Maxim 2 (Time Period) constrained by tax rate increases?

The cost of the rate increases (if it does in the future) may offset the benefit of the deferral

Why is the jurisdiction variable important?

Because local, state, and foreign tax laws differ

What is Tax Planning Maxim 3 (Jurisdiction)?

Tax costs decrease (and cash flows increase) when income is generated in a low tax rate jurisdiction

What is ordinary income?

Income generated from sale of goods or performance of services in the regular course of business

Income generated by investments

What are capital gains?

Generated by the sale or exchange of capital assets

How is ordinary income taxed? What are 2 exceptions?

Taxed at regular rates

Exceptions include

1. Municipal Bonds (tax-exempt)

2. Qualified Dividends (taxed at preferential rates for individuals)

How are capital gains taxed?

1. Taxed at preferential rates for INDIVIDUALS

2. Taxed at regular rates for CORPORATIONS

What is Tax Planning Maxim 4 (Character)?

Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character

What is an implicit tax? What is an example?

A reduced before-tax rate of return because the investment is tax-favored

A corporate bond pays 9% and a municipal bond pays 6.3% - since the corporate bond is taxable, a higher rate of return is required

What is the Economic Substance Doctrine?

A transaction that does not change the taxpayer's economic situation except by the tax savings from the transaction can be disregarded by the IRS

What is the Business Purpose Doctrine? In what section is this doctrine found?

A transaction must have a business purpose other than tax avoidance

Section 7701 (o)

What is the Substance Over Form Doctrine?

The IRS can look through legal formalities to determine economic substance of a transaction

If the economic reality (substance) is different from the legal structure (form), the IRS will base tax consequences off of substance

What is the Step Transaction Doctrine?

The IRS can collapse a series of interdependent transactions into one transaction

Person 1 (related) - Person 2 (unrelated) - Person 3 (related)