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ch 3 gottlieb tax

Learning Objectives

  • Identify the objectives of basic tax planning strategies.
  • Apply the timing strategy.
  • Apply the concept of present value to tax planning.
  • Apply the income-shifting strategy.
  • Apply the conversion strategy.
  • Describe basic judicial doctrines that limit tax planning strategies.
  • Contrast tax avoidance and tax evasion.

Basic Tax Planning Overview

  • Effective tax planning must consider both tax and nontax factors to maximize a taxpayer's after-tax wealth while achieving nontax goals.
  • There are three parties involved in transactions: the taxpayer, the other transacting party, and the government.
  • The three basic planning strategies are:
    • Timing
    • Income shifting
    • Conversion

Timing Strategies

  • Timing affects the real tax costs or savings due to:
    1. The present value of taxes on income or tax savings on deductions.
    2. Variations in tax costs as tax rates change.
  • Present Value Concept: $1 today is worth more than $1 in the future. This impacts tax planning as present values are base considerations for inflows (to be maximized) and outflows (to be minimized).

Present Value Example

  • Bill and Mercedes purchased $1,000 worth of furniture with no immediate payment. Given a 10% after-tax return, the present value of $1,000 today is calculated as:
    • Present Value = $1000 × 0.909 = $909
    • Savings of $91 ($1,000 - $909).

Basic Timing Strategies

  • Accelerating deductions: Move current cash inflows forward.
  • Deferring income: Postpone current outflows.

Tax Rates Changes Strategy

  1. If tax rates increase:
    • Calculate if accelerating deductions is more beneficial than deferring them into a lower-tax-rate year.
    • Compare if deferring income outweighs recognizing income in a higher level.
  2. If tax rates decrease:
    • Accelerate deductions into previous years to benefit from a higher deduction time frame.
    • Deferring income can minimize taxes when rates are lower.

Limitations to Timing Strategies

  • Often, accelerating deductions requires actual cash outflow.
  • Laws often mandate continued investment to defer income recognition.
  • Cash flow needs may restrict deferral strategies.
  • Constructive receipt doctrine: Income must be taxed when it is actually or constructively received.

Income-Shifting Strategies

  • Income shifting takes advantage of tax rate differences among individuals and jurisdictions by moving income from high-tax to low-tax entities.
  • Types of Income Shifting:
    • Family transactions: Parents shift income to lower taxed children (like from allowances).
    • Business owners: Strategy to shift income from higher to lower tax entities through various deductions.
    • Jurisdiction based: Taxes can differ based on geographic location, allowing tax planning to exploit such differences.

Limitations to Income-Shifting Strategies

  • IRS scrutiny on related-party transactions, potential implicit taxes might decrease benefits.

Conversion Strategies

  • Conversion strategies exploit different taxation rates on varying types of income:
    • Ordinary income is taxed higher than long-term capital gains and sometimes tax-exempt earnings.
  • To implement, one must:
    1. Understand tax treatment of various incomes/expenses.
    2. Have the ability to adjust the income or expense type to gain a favorable tax outcome.

Conversion Example

  • Bill compares three investments with the same risk:
    • High-dividend stock at 8.5%,
    • Taxable corporate bonds at 9.7%,
    • Tax-exempt municipal bonds at 6%.
  • Conclusion from the hypothetical case study would show which investment yields the highest returns after tax considerations.

Limitations of Conversion Strategies

  • Provisions exist to prevent changing income types artificially.
  • Implicit taxes can undermine the effectiveness of conversion strategies.
  • Judicial doctrines may impose restrictions:
    • Assignment of Income: Income must be taxed to the entity earning it.
    • Business Purpose Doctrine: IRS may disallow expenses lacking genuine business intention.
    • Substance-over-form Doctrine: Transactions can be reclassified based on their real substance rather than legal form.

Tax Avoidance vs. Tax Evasion

  • Tax Avoidance: Legally arranging affairs to minimize taxes is acceptable.
  • Tax Evasion: Willful attempts to hide income or misrepresent facts to avoid tax can lead to criminal penalties.
    • Tax avoidance strategies discussed are legal; evasion is illegal and punishable.