Chapter 4: Maxims of Income Tax Planning

Tax avoidance

legitimate means of reducing taxes

-still involve major questions of judgement

-are they ethical? Every person has the civic responsibility of paying the legally required tax and not a penny more.

tax evasion

illegal means of reducing taxes

-federal crime- a felony offence punishable by severe monetary fines and imprisonment

what is the goal of tax planning

maximize after-tax returns/tax flows; not minimize taxes on an individual period basis

What makes income tax planning possible?

-income tax is not neutral

--> in every case in which the law applies differently to a certain dollar of business profit or cost, a planning opportunity is born

-not everything is treated the same so there is a lot of nuance

The tax consequences of a transaction depend on the interaction of 4 variables common to all transactions

1. the entity variable: which entity undertakes the transaction?

2. The time period variable: During which tax year or years does the transaction occur?

3. The jurisdiction variable: In which tax jurisdiction foes the transaction occur?

4. The character variable: what is the tax character of the income from the transaction

The entity variable

-in the federal tax system, individuals and corporations are the two entities that pay tax on business income

-businesses can be sole proprietorships, partnerships, LLCs, or S corps; but these organizational forms are not taxable entities. Income generated by a proprietorship, partnership, LLC, or S corp is taxed to the proprietor, partners, members, or shareholders

-the amt of taxable income from a business activity doesn't depend on the type of entity conducting the business; the tax law is neutral across entities with respect to the tax base

ex: tax rates for individuals are based off of income brackets; corporate earnings are taxed at a flat rate of 21%; individual rate structures are processive, so the tax rate on any given dollar of income depends on the marginal rate of the entity earning that dollar (lower marginal rate= less tax)

Income shifting

a technique used to reduce taxes in which a taxpayer shifts a portion of income to relatives in lower tax brackets

Deduction shifting

Arranging transactions for the purpose of transferring deductions from a low tax rate entity to a high tax rate entity

Constraints on Income Shifting

-income shifts usually occur between related parties. After the income shift, the parties in the aggregate are financially better off by the tax savings from the transaction

-income shifting techniques loose revenue for the Treasury

-if a transaction serves no genuine purpose besides tax avoidance, the IRS may disallow the tax consequences intended by the parties

assignment of income doctrine

-the fed courts say that out income tax system cannot tolerate artificial shifts of income from one taxpayer to another

--> income must be taxed to the person who earns it, even if another person has a legal right to the wealth represented by the income

-assignment of income doctrine: Income must be taxed to the entity that renders the service or owns the capital with respect to which the income is paid

The time period variable

-fed and state income taxes are imposed annually, so the tax costs or savings from a transaction depend on the year in which the transaction occurs

-as tax rates change each year, tax costs and savings will also fluctuate

-also, a tax benefit available in one year may disappear in the next; a statutory restriction causing a tax problem this year may be lifted in the future

-when managers control the timings of transactions they may reduce the tax cost or increase the tax savings for their firm

-time value of money also affects the costs and savings from transactions (a tax dollar paid this year costs more than a tax dollar paid in a future year; a tax dollar saved this year is worth more than a tax dollar saved in the future)

--> tax costs decrease and cash flows increase when a tax is deferred until la later taxable year

Income deferral and opportunity costs

-firms can defer tax only by deferring the taxable income generated by the transaction, which may be difficult to do without affecting cash flows

-a tax deferral strategy that does affect before-tax cash flows may not improve NPV

Income deferral and rate changes

-the deferral of taxable income into future years creates uncertainty as to the marginal rates that will apply to that income

-the value of the deferral could be reduced if congress were to increase the statutory rates or if the firm were to move unexpectedly into a higher tax bracket

-the risk that deferred income will be taxed at a higher rate escalates with the length of the deferral period

The Jurisdiction Variable

-every domestic business is subject to the tax jurisdiction of the federal government, so geographic location of a firm within the US is a neutral factor in the computation of its federal income tax

-but... most states also tax business income

-a firm's aggregate income tax liability (fed, state, and local) is a function of the jurisdiction in which it conducts its business

The character variable

-is the character of the income generated by transactions

-the tax character of any item of income is determined strictly by law; it is not intuitive and may bear no relationship to any financial or economic attribute of the income

-the character of income and the ramifications of that characterization can change with each new tax bill passed by congress or each new regulation published by the treasury

-because the character variable is artificial, it is the hardest one to discuss in a generalized manner

-every item of income is characterized for tax purposes as either ordinary income or capital gain

-many items of ordinary income and capital gain have additional characteristics that affect the tax on income

ordinary income

income generated by routine sales of goods or services to customers or clients

-the yield on certain types of invested capital, such as interest and rents is also ordinary in character

-most ordinary income is taxed at the regular individual or corporate rates

capital gain

-the sale or exchange of certain types of property, referred to as capital assets, gives rise to capital gain

-capital gains have favorable treatment under the federal tax law, usually in the form of a preferential tax rate

determining the value of preferential rates

-can only be quantified by reference to that taxpayer's regular marginal rate

constraints on conversion

-try to structure transactions to result in a capital gain rather than ordinary income

-sp congress works to protect the integrity of the distinction between the two types of income

explicit tac

an actual tax liability paid directly to the taxing jurisdiction

implicit tax

the reduction in before-tax rate of return that investors are willing to accept because of the tax-favored characteristics of an investment

Developing tax planning strategies

our analysis of the variables that determine the tax consequences of transactions resulted in the following maxims:

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

-in pv terms, tax costs decrease (and cash flows increase) when a tax is deferred until a later taxable year

-tax cost decrease (and cash flow increase) when income is generated in a jurisdiction with a low tax rate

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

--> tax planning strategies that enhance cash flows typically reflect at least one of these maxims

-many strats will combine two or more maxims working together to minimize taxes. Others might adhere to one and violate the other

additional strategic considerations

managers should remembe that their straegic goal is not to minimize but maximize after tax value

-there is an expense of implementing the strategy

-remember the tax strategies of all parties

-tax strats must be evaluated on the basis of flexibility

tax legal doctrines

managers must be confident that they idetified the correct tax consequences of the strats implemented by their firm and think about how the govt will react to it

economic substance doctrine

A transaction that doesn't change the taxpayer's economic situation except by the tax savings from the transaction should be disregarded for tax purposes.

business purpose doctrine

a transaction should not be effective for tax purposes unless it is intended to achieve a genuine and independent business purpose other than tax avoidance

substance over form doctrine

The IRS can look through the legal formalities to determine the economic substance (if any) of a transaction and to base the tax consequences on the substance instead of the form.

step transition doctrine

The IRS can collapse a series of intermediate transactions into a single transaction to determine the tax consequences of the arrangement in its entirety