Maxims of Income Tax Planning - Chp. 4 Law Terms & Definitions

capital gain

a profit from the sale of property or of an investment.

explicit vs. implicit tax

pay the rate vs. built-in (ex: tax-exempt interest on a bond w/ lower return)

tax avoidance

consists of legitimate means of reducing taxes (allowed by law, potentially morally questionable)

tax evasion

illegal means of reducing taxes

4 maxims/variables of tax planning

entity, time period, jurisdiction, character variable

entity variable

which entity undertakes the transaction

time period variable

which tax year does the transaction occur

jurisdiction variable

In which tax jurisdiction does the transaction occur?

character variable

what is the tax character of the income, gain, loss, or deduction

ordinary, capital, exempt

tax on income

taxable income computed under same rules across entities

tax on bus. income depends on difference in tax rates across entities

2 taxpaying entities: individ. + corporation

How do individ. file taxes

- Form 1040

- Schedule C

- progressive tax structures 10-37% (partially dependent on martial status)

- rate schedules included in Appendix C

How corporations file taxes

Form 1120

proportionate tax rate = 21%

Entity Variable Maxim 1

tax costs dec. (cash flows inc.) when income is generated by an entity subject to a low tax rate

Income shifting

arrange transactions to transfer income from high tax rate entity to low tax rate entity

usually occurs w/ related parties

Deduction shifting

transfer deductions from low to high tax rate entity

effect of tax planning maxim

income/deduction shift => aggregate benefits are shared

assignment of income doctrine

- constraint on income shifting (rules)

- income must be taxed to entity that earns it from sale of goods/performance of services

- income generated by capital must be taxed to entity that owns the capital

Time Period Variable Maxim 2

In PV terms, tax costs dec. (and cash flows inc.) when tax is deferred until a later taxable year

Constraints for the Time Period Variable Maxim

- opportunity costs

- tax rate inc.

Opportunity Cost with Timing Maxim

- shifting tax costs to later period postpone the cash inflow (its immediate use)

- tax rate inc, postpone to future year means cost > benefit of deferral

Deferred Income

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

Jurisdiction Variable Maxim 3

important bc local, state, foreign tax laws differ

tax costs dec. (cash flows inc.) when income generated in low tax rate jurisdiction

- don't only focus on tax, consider other jurisdiction considerations too

Character Variable Maxim 4

tax costs decrease (CF increase) when income taxed at preferential rate bc of its character

ordinary income vs capital gains

Ordinary income

sale of G/S in regular course of bus, income from investments (rent, interest, dividends, royalties, et.) = ordinary

- taxed at regular rates

Capital Gains

generated by sale/exchange of capital assets

- get preferential rate bc. gov. wants to incentivize investments in capital

- 1221 of tax code

Exceptions to regular tax rate on ordinary income

- interest on municipal (state/local) bonds = tax exempt

- qualified dividends = preferential rate for individuals

capital gains tax rate for individuals vs. corporations

individuals = preferential rate

corporations = regular rate

Incentives regarding Character Maxim of tax planning

- capital gains = preferential rate so ppl. try to arrange transactions to convert ordinary income => CG (IRS tries to prevent that w/ provisions)

implicit tax

built-in tax

ex: municipal bond has lower rate of return compared to corporate bond, difference/higher rate = tax rate

manager's ultimate strategic goal

NPV maximization not tax minimization

legal doctrines used by the IRS to challenge tax planning strategy

- economic substance/bus. purpose doctrine

- substance > form doctrine

- step transaction doctrine

ess. for related party transactions, which IRS pays extra attention to

economic substance/bus. purpose doctrine

transaction must have bus. purpose other than tax avoidance, codified in 7701

substance > form

look through legal formalities to determine economic substance

step transaction doctrine

collapse transactions into 1 (that prob. wouldn't be allowed) to enforce