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.