CH.3 Tax Planning Strategies and Related Limitations

Three Basic Tax Planning Strategies

1. Timing 2. Income Shifting 3. Conversion

Name three common types of income shifting.

Income shifting from high tax rate parents to low tax rate children; income shifting from businesses to their owners; taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions.

Bendetta, a high-tax-rate taxpayer, owns several rental properties and would like to shift some income to her daughter, Jenine. Bendetta instructs her tenants to send their rent checks to Jenine so Jenine can report the rental income. Will this shift the income from Bendetta to Jenine? Why or why not?

Merely sending the checks to Jenine is not sufficient to shift the rental income from Bendetta to Jenine under the assignment of income doctrine. To shift the rental income to Jenine, she must earn the income. In this case, this means that Jenine must actually own the rental property to report the rental income.

Using the facts from the previous problem, how would your answer change if instead, Duff adopted the cash method of accounting to allow him to better control the timing of his cash receipts and disbursements?

This strategy would fall within the confines of legitimate tax planning, and thus, Duff should not be subject to the potential risks associated with tax evasion.

Tax Planning

the goal of tax planning is to maximize the taxpayer's after-tax wealth while simultaneously achieving the taxpayer's nontax goals. Maximizing after-tax wealth is not necessarily the same as tax minimization. Specifically, 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 (i.e., taxes).

Tax evasion

the willful attempt to defraud the government -This is outside the confines of legal tax avoidance. -May land the taxpayer in prison -Example: Deliberately excluding income from your tax return or adding extra expenses that were not paid.

tax avoidance

using tax planning strategies to legally reduce your tax burden The 3 tax planning strategies fall under legal tax avoidance. -Endorsed by the courts and Congress -Example: Congress encouraged tax avoidance by -excluding municipal bond income from taxation and preferentially taxing dividend and capital gain income.

Timing: Deferring or accelerating taxable income and tax deductions.

Example: It is the end of December and you need to purchase some expensive equipment for your business. Your current year income is low, and thus you expect to fall in a low tax bracket. You also expect sales to greatly increase next year, putting you into a high tax bracket. When should you buy the equipment?

Income Shifting: Shifting income from high- to low-tax-rate taxpayers.

Example: Your business is thriving and you expect to be in a high tax bracket for the year. Your daughter is interested in picking up some work to earn a little cash, and she will likely fall in the lowest tax bracket. What could you do to shift some of your income from your high tax rate to her low tax rate?

Conversion: Converting income from high- to low-tax rate activities.

Example: Your current savings account at the bank generates around $100 of taxable interest income each year. You want to explore other investing options to see if you can convert this income from high to low rate activities. What are some options?

What are some ways that a parent could effectively shift income to a child? What are some of the disadvantages of these methods?

Parents who own a business may shift income to their children by employing them to work for the business. Because this is a related-party transaction, it is important for the substance of the transaction to be justifiable, not just the form of the transaction. One disadvantage of this method is that it requires the children to actually perform services for the parent's business, which may or may not be a positive factor given the skill set of the children and the ability of the family to work together in harmony. Parents may also shift investment income to their children by transferring the underlying investments to the children. The disadvantages of this strategy are somewhat obvious—many parents may not be able to afford to transfer significant wealth to their children or would have serious reservations about doing so. The "kiddie tax" may also apply when parents shift too much investment income to children. The kiddie tax restricts the amount of a child's investment income that can be taxed at the child's (lower) tax rate instead of a higher tax rate.

Why is the timing strategy particularly effective for cash-method taxpayers?

The timing strategy is particularly effective for cash-method taxpayers because the deduction year for cash-method taxpayers depends on when the taxpayer pays the expense (which the taxpayer controls).

Tax Avoidance vs. Tax Evasion

Tax avoidance is legal. Tax evasion is hiding, misrepresenting, or otherwise not recognizing income so as to illegally avoid taxation.

What is the difference between tax avoidance and tax evasion?

Tax avoidance is the legal act of arranging one's affairs to minimize taxation. It has long been endorsed by the courts and Congress. In contrast to tax avoidance, tax evasion (willful intent to defraud the government) falls outside the confines of legal tax avoidance. In many cases there is a clear distinction between avoidance (e.g., not paying tax on municipal bond interest) and evasion (e.g., not paying tax on $1,000,000 game show prize). In other cases, the line between tax avoidance and evasion is less clear. In these situations, professional judgment, the use of a "smell test," and consideration of the business purpose, step transaction, and substance-over-form doctrines may prove useful.

What are some common examples of the timing strategy?

The timing strategy is an important aspect of investment planning, retirement planning, and property transactions It is also an important aspect of tax planning for everyday business operations (e.g., determining the appropriate period to recognize sales income - upon product shipment, delivery, or customer acceptance). Some common examples of the timing strategy include accelerating depreciation deductions for depreciable assets, using LIFO versus FIFO for inventory, accelerating the deduction of certain prepaid expenses, etc.