Chapter 3: Tax Planning Strategies and Related Limitations

2 basic tax-related timing strategies when tax rates are constant?

1. Accelerate tax deductions (deduct in an earlier period) 2. Defer recognizing taxable income (recognize in a later period)

The timing tax strategy when tax rates are increasing

1. Tax deductions: require calculation to determine optimal strategy => The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower-tax-rate year 2. Taxable income: requires calculation to determine optimal strategy => The taxpayer must calculate whether the benefit of deferring income outweighs the disadvantage of recognizing income in a higher-tax-rate year

Select the two most important considerations that are necessary for effective tax planning for individuals. Multiple select question. A. Maximizing after-tax wealth B. Maximizing government revenue C. Minimizing taxes D. Achieving non-tax related goals

A. Maximizing after-tax wealth D. Achieving non-tax related goals

The discount factor for a one-year investment earning a rate of return of 3 percent is equal to ____

$1/(1+.03) = 0.971

When considering cash outflows __________

LOWER present values are preferred

Present value formula

PV=FV/(1+r)^n

How should a taxpayer evaluate whether it is advantageous to accelerate a tax deduction in a period of tax rate increases? Multiple choice question. A. The taxpayer needs to compare the tax-savings from the deduction in the current year to the present value of the tax-savings in one year. B. The taxpayer should always choose to take the deduction in the high-tax-rate year if there is an option. C. The taxpayer should always take the deduction in the current year to minimize current taxes.

A. The taxpayer needs to compare the tax-savings from the deduction in the current year to the present value of the tax-savings in one year.

Under what circumstances might a taxpayer want to defer the recognition of income? (Check all that apply.) Multiple select question. A. When setting aside money for retirement B. When the taxpayer expects to be in a higher tax bracket in the future C. When the actual receipt of the income does not have to be postponed very long D. When the rate of return on an investment is projected to increase

A. When setting aside money for retirement C. When the actual receipt of the income does not have to be postponed very long

Limitations on certain tax benefits, such as depreciation for luxury automobiles, often decrease or eliminate the benefits of ______ strategies. Multiple choice question. A. conversion B. income shifting C. timing D. diversion

A. conversion

True or False: The timing strategy is based on the idea that the period in which income is taxed affects the tax costs of the income.

False

Nina can choose to receive $5,000 today or $5,000 a year from now. If she takes the money now and invests the money at a 6% interest rate (after tax), she will have $ ______one year from now. (The answer should be in the form of amounts rather than words.)

Future value = present value x (1 + r)^n = $5,000 x (1 + 0.06)^1 = $5,300

When considering cash inflows _________

HIGHER present values are preferred

After-tax rate of return

a taxpayer's before-tax rate of return on an investment minus the taxes paid on the income from the investment. The formula for an after-tax rate of return that is taxed annually is the before-tax rate of return × (1 − marginal tax rate) [i.e., r = R × (1 − t)]. A taxpayer's after-tax rate of return on an investment held for more than one tax period is r = (FV/I)1/n − 1, where r is the after-tax rate of return, FV is the after-tax future value of the investment, I is the original investment amount, and n is the number of periods the investment is held.

The tax planning strategy based on the understanding that the tax law does NOT treat all types of income and deductions the same is the ___________ strategy.

conversion

Related-party transaction

financial activities among family members, among owners and their businesses, or among businesses owned by the same owners

A lower rate of return on tax-exempt securities than the rate earned on similar taxable securities is an example of a(n) _________ tax which often reduces or negates the benefits of conversion strategies.

implicit

Step-transaction doctrine

judicial doctrine that allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction

Substance-over-form doctrine

judicial doctrine that allows the IRS to consider the transaction's substance regardless of its form and, where appropriate, reclassify the transaction according to its substance

Economic substance doctrine

judicially based doctrine that requires transactions to meaningfully change a taxpayer's economic position and have a substantial purpose (apart from a federal income tax purpose) in order for a taxpayer to obtain tax benefits

A $1 today is worth ________ than $1 in the future.

more

Present value

the concept that $1 today is worth more than $1 in the future. For example, assuming an investor can earn a 5 percent after-tax return, $1 invested today should be worth $1.05 in one year. Hence, $1 today is equivalent to $1.05 in one year

Business purpose doctrine

the judicial doctrine that allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation

Calculate the discount factor for one period for an investment given a rate of return equal to 6 percent. Multiple choice question. A. 0.060 B. 0.943 C. 1.06 D. 0.167

Present value = future value/(1+r)^n = $1/(1+0.06)^1 = $0.943

The implication of the time value of money for tax planning:

The timing of a cash inflow or a cash outflow affects the present value of the income or expense

Using the attached table, what is the present value today of $2,300 received two years from now with a rate of return equal to 4%? The column headers are marked from left to right as: Year, four percent, five percent, six percent, and seven percent. The year wise data is presented as follows: 1: 0.962, 0.952, 0.943, and 0.935. 2: 0.925, 0.907, 0.890, and 0.873. 3: 0.899, 0.864, 0.840, and 0.816. 4: 0.855, 0.823, 0.792, and 0.763. 5, 0.822, 0.784, 0.747, and 0.713.

$2,300 x .925 = $2,127.50

Identify the objectives of basic tax planning strategies

*Effective tax planning maximizes the taxpayer's after-tax wealth while achieving the taxpayer's nontax goals. Maximizing after-tax wealth is not necessarily the same as tax minimization. Maximizing after-tax wealth requires one to consider both the tax and nontax costs and benefits of alternative transactions, whereas tax minimization focuses solely on a single cost *Virtually every transaction involves 3 parties: the taxpayer, the other transacting party, and the uninvited silent party that specifies the tax consequences of the transactions

Limitations to the timing strategy

1. Whenever a taxpayer is unable to accelerate a deduction without aso accelerating the cash outflow 2. Tax law generally requires taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes 3. A deferral strategy may not be optimal if the taxpayer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unnecessary risk 4. The constructive receipt doctrine, which provides that a taxpayer must recognize income when it is actually or constructively received, also restricts income deferral for cash-method taxpayers

Andre has the option of receiving $1,800 today or $1,860 a year from now. Assuming Andre can invest the money and earn 4 percent this year, he would have $_____ a year from now. He should take the $_____ (1,800/1,860)

1/ Future value = present value x (1 + r)^n = $1,800 x (1+.04)^1= $1,872 2/ $1,800

When tax rates are constant or ______, taxpayers should accelerate tax deductions and defer taxable income. Multiple choice question. A. decreasing B. increasing

A. decreasing

In addition to accelerating deductions, the timing strategy of ______ income recognition is beneficial to many taxpayers. Multiple choice question. A. deferring B. eliminating C. accelerating D. converting

A. deferring

A common income shifting strategy is to: A. shift income from a high tax rate jurisdiction to a low tax rate jurisdiction. B. shift income from a low tax rate jurisdiction to a high tax rate jurisdiction. C. invest in tax exempt bonds. D. defer income.

A. shift income from a high tax rate jurisdiction to a low tax rate jurisdiction. Explanation Income shifting attempts to shift income from high tax rate to low tax rate taxpayers or jurisdictions and deductions from low tax rate to high tax rate taxpayers or jurisdictions.

Which of the following tax planning strategies is based on the understanding that the tax law does NOT treat all types of income and deductions the same? Multiple choice question. A. Timing strategy B. Conversion strategy C. Income assignment strategy D. Income shifting strategy

B. Conversion strategy

Which of the following is NOT necessarily a part of effective tax planning? Multiple choice question. A. Maximizing after-tax wealth B. Minimizing tax payments C. Achieving nontax goals

B. Minimizing tax payments

Which one of the following choices describes an income shifting tax planning strategy? Multiple choice question. A. Accelerating tax deductions to a high-tax year B. Moving income to more tax favorable jurisdictions C. Converting the type of income to a more tax favored source D. Deferring income to a low-tax-year

B. Moving income to more tax favorable jurisdictions

Which of the following items is illegal under the tax law? A. Tax avoidance B. Tax evasion C. Accelerating deductions D. Deferring income E. All of the choices are legal

B. Tax evasion Explanation Tax evasion is illegal and may land the perpetrator within the confines of a federal prison.

All other things being equal, taxpayers should prefer to recognize income during ______ tax-rate years and deductions during _______ tax-rate years.

Blank 1: low, lower, or declining Blank 2: high, higher, or accelerating

Which of the following options are limitations of a timing strategy? (Choose all that apply.) Multiple select question. A. The assignment of income doctrine dictates that the person/entity earning the income cannot assign the income and tax consequences to another. B. The constructive receipt doctrine often prevents income from being deferred to a later period. C. Taxpayers can sometimes choose to accelerate the recognition of tax deductible expense. D. Tax laws generally require taxpayers to continue their investment in an asset in order to defer income recognition.

B. The constructive receipt doctrine often prevents income from being deferred to a later period. D. Tax laws generally require taxpayers to continue their investment in an asset in order to defer income recognition.

Under which of the following situations is a strategy for the timing of deductions most beneficial? (Check all that apply.) Multiple select question. A. When the transaction is small B. When tax rates are high C. When tax deductions can be accelerated without accelerating the cash outflow D. When the taxpayer is expecting to be taxed at a higher rate in the future E. When the taxpayer is earning a high rate of return F. When tax rates are low G. When the transaction is large

B. When tax rates are high C. When tax deductions can be accelerated without accelerating the cash outflow E. When the taxpayer is earning a high rate of return G. When the transaction is large

When tax rates are decreasing, taxpayers should ____ tax deductions and _____ taxable income.

Blank 1: accelerate or accelerating Blank 2: defer, postpone, or deferring

In order for a related-party transaction to be acceptable to the IRS, it should be structured as a(n) _________ ___________transaction.

Blank 1: arm's, arms, arm, or arms' Blank 2: length

Because it often restricts the income deferral for cash-method taxpayers, the _______ ________ doctrine is a limitation of a timing strategy.

Blank 1: constructive Blank 2: receipt or receipts

An effective income shifting strategy for a corporation and an employee-owner involves generating a tax ________ for one party while generating taxable ____________ for the other party.

Blank 1: deduction, deductions, or deductible Blank 2: income

When tax rates are constant, tax planning suggests that taxpayers should consider ______ the recognition of income.

Blank 1: deferring, postponing, delaying, or defer

The impact of the tax rate on a transaction must be considered along with the ___________ __________of the transaction to determine if the benefits of accelerating the transaction outweigh the disadvantages.

Blank 1: present Blank 2: value

There are three basic tax planning strategies that represent the building blocks of tax planning. These strategies include _________, income shifting, and _________

Blank 1: timing or time Blank 2: conversion

Which of the following statements is correct regarding present value? Multiple choice question. A. It would be better to receive $50 a year from now than to receive $50 today. B. A $1 today is worth the same as $1 in the future. C. A $1 today is worth more than $1 in the future. D. A $1 today is worth less than $1 in the future.

C. A $1 today is worth more than $1 in the future.

Which of the following is an example of the conversion strategy? A. Accelerating deductions. B. Deferring income. C. An employer providing tax free benefits to employees instead of salary. D. A high-tax rate parent employing her low-tax-rate son in the family business.

C. An employer providing tax free benefits to employees instead of salary. Explanation A common conversion strategy is for employers to pay employees with tax-free employee benefits instead of taxable salary, thus converting taxable compensation to nontaxable compensation.

The assignment of income doctrine most likely limits which of the following strategies? A. Conversion B. Timing C. Income shifting D. Tax minimization E. None of the choices are correct.

C. Income shifting Explanation The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns it and most often limits the income shifting strategy.

Which of the following methods will NOT result in a tax beneficial shift of income from a corporation to its employee-owner? Multiple choice question. A. Renting property from the employee-owner B. Borrowing money from the employee-owner C. Paying dividends to the employee-owner D. Paying compensation to the employee-owner

C. Paying dividends to the employee-owner

Which of the following doctrines is NOT used by the IRS to examine transactions where it expects taxpayer abuse? A. Multiple choice question. B. Step-transaction doctrine C. Tax minimization doctrine D. Substance-over-form doctrine E. Business purpose doctrine E. Economic substance doctrine

C. Tax minimization doctrine

Which of the following choices is an advantage of shifting income across jurisdictions? Multiple choice question. A. Taxpayers often receive less scrutiny from the IRS when operating in multiple jurisdictions. B. The public is generally supportive of companies moving operations out of the U.S. in order to reap tax and other financial benefits. C. The differences in tax rates and tax laws across jurisdictions can often be used to maximize after-tax wealth. D. The IRS is likely to closely scrutinize companies who operate in multiple jurisdictions.

C. The differences in tax rates and tax laws across jurisdictions can often be used to maximize after-tax wealth.

Which of the following transactions would NOT be acceptable to the IRS as a means of switching the taxable income to another taxpayer? Multiple choice question. A. Giving a gift of the taxpayer's stock to her son B. Selling a taxpayer's assets to her business at fair market value C. Transferring interest income from a taxpayer's investment to his young daughter

C. Transferring interest income from a taxpayer's investment to his young daughter

When tax rates are constant, taxpayers should ______ tax deductions and ______ recognizing taxable income. Multiple choice question. A. accelerate; accelerate B. defer; accelerate C. accelerate; defer D. defer; defer

C. accelerate; defer

What do tax savings represent?

Cash inflows

What do taxes paid represent?

Cash outflows

Which of the following strategies exploits the fact that tax rates vary by activity (e.g., income type)? A. Timing B. Present value C. Income shifting D. Conversion E. Evasion

D. Conversion Explanation The conversion strategy is based on the idea that different activities are subject to different tax rates. For example, ordinary income such as salary, interest income, and business income received by individual taxpayers is taxed at their ordinary marginal tax rates, whereas long-term capital gains, which are gains from the sale of investment assets held longer than one year, and dividends are taxed at lower tax rates (currently a maximum of 20 percent), and still other forms of income like nontaxable compensation benefits and municipal bond interest are tax-exempt.

Which of the following statements is INCORRECT regarding income shifting strategies across jurisdictions? Multiple choice question. A. The differences in tax rates and tax laws across jurisdictions can often be used to maximize after-tax wealth. B. Although tax laws may be more favorable in other countries, negative publicity may hamper operations of companies who move operations overseas. C. The IRS is likely to closely scrutinize companies who operate in multiple jurisdictions. D. Taxpayers that operate in multiple countries should always incorporate in the country with the lowest tax structure in order to pay taxes in that country.

D. Taxpayers that operate in multiple countries should always incorporate in the country with the lowest tax structure in order to pay taxes in that country.

True or false: All other things being equal, taxpayers should prefer to recognize income during high-tax-rate years.

False

True or false: Neither tax avoidance nor tax evasion is acceptable or legal in the U.S

False

True or false: Accelerating tax deductions to an earlier period DECREASES the present value of the tax savings from the deductions

False Accelerating tax deductions to an earlier period INCREASES the present value of the tax savings from the deductions. That is, tax savings received now have a higher present value than the same amount received a year from now

True or false: Deferring income to a later period increases the present value of the tax cost of the income

False Deferring income to a later period DECREASES the present value of the tax cost of the income => taxes paid a year from now have a lower present value than taxes paid today.

True or False: If tax rates will be the same next year, the taxpayer should generally accelerate deductions. Group starts

True

True or False: The goal of tax planning is to maximize after-tax wealth.

True

True or False: The income shifting strategy exploits the fact that tax rates vary across taxpayers or jurisdictions. Group starts

True

True or False: The present value concept becomes more important as interest rates increase.

True

Before-tax rate of return

a taxpayer's rate of return on an investment before paying taxes on the income from the investment

The tax planning strategy known as ______ shifting encompasses shifting earnings and deductions from (1) taxpayers in one rate bracket to taxpayers in a different rate bracket, and (2) one jurisdiction to a more tax favorable jurisdiction. (Enter only one word per blank.)

income

Implicit taxes

indirect taxes that result from a tax advantage the government grants to certain transactions to satisfy social, economic, or other objectives. They are defined as the reduced before-tax return that a tax-favored asset produces because of its tax-advantaged status

Discount factor

the factor based on the taxpayer's rate of return that is used to determine the present value of future cash inflows (e.g., tax savings) and outflows (taxes paid)

Assignment of income doctrine

the judicial doctrine holding that earned income is taxed to the taxpayer providing the service, and that income from property is taxed to the individual who owns the property when the income accrues

Constructive receipt doctrine

the judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayer's account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income's availability, and there are no restrictions on the taxpayer's control over the income

Tax avoidance

the legal act of arranging one's transactions or affairs to reduce taxes paid

Tax evasion

the willful attempt to defraud the government (i.e., by not paying taxes legally owed). Tax evasion falls outside the confines of legal tax avoidance

Generally, whenever a taxpayer can accelerate a tax deduction without accelerating the cash outflow, the _______ strategy will be beneficial.

timing

Match the three basic tax planning strategies with their description: timing income shifting conversion accelerating tax deductions and deferring the recognition of taxable income moving income and deductions from taxpayers in one tax bracket to taxpayers in a different tax bracket charging the type of income to a more tax-favored form of income

timing: accelerating tax deductions and deferring the recognition of taxable income income shifting: moving income and deductions from taxpayers in one tax bracket to taxpayers in a different tax bracket conversion: changing the type of income to a more tax-favored form of income

Arm's-length transactions

transactions among unrelated taxpayers, where each transacting party negotiates for his or her own benefit