Chapter 3 HW Tax Planning Strategies and Related Limitations

Do after-tax rates of return for investments in either interest- or dividend-paying securities increase with the length of the investment? Why or why not?

After-tax rates of return do not increase for interest- or dividend-paying securities with the length of the investment period because they are both taxed annually.

The concept of the time value of money suggests that $1 today is not equal to $1 in the future. Explain why this is true.

Assuming an investor can earn a positive return (e.g., 5 percent), $1 invested today should be worth $1.05 ($1 × (1+.05)1) in one year. Hence, $1 today is equivalent to $1.05 in one year.

Explain why paying dividends is not an effective way to shift income from a corporation to its owners.

Because corporations do not get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Instead, paying dividends results in "double taxation"—the profits generating the dividends are taxed first at the corporate level, and then the dividends are taxed at the shareholder level.

What factors increase the benefits of accelerating deductions or deferring income?

Higher tax rates, higher interest rates, larger transaction amounts, and the ability to accelerate deductions by two or more years increase the benefits of accelerating deductions. Likewise, higher tax rates, higher interest rates, larger transaction amounts, and the ability to defer revenue recognition for longer periods of time increase the benefits of income deferral.

What are some of the common examples of the conversion strategy?

In the Investments chapter, we consider investment planning and the advantages of investing in assets that generate preferentially taxed income. In the Business Income, Deductions, and Accounting Methods chapter, we explain the basic differences between business and investment activities and what characteristics result in the more favorable "business" designation for expense deductions. In the Compensation and Retirement Savings and Deferred Compensation chapters, we discuss compensation planning and the benefits of restructuring employee compensation from currently taxable compensation to nontaxable or tax deferred forms of compensation, such as employer-provided health insurance and retirement contributions.

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.

What factors have to be present for income shifting to be a viable strategy?

Income shifting requires: (1) a legitimate method of shifting income that will withstand IRS scrutiny and (2) either (a) related parties, such as family members or businesses and their owners, who have varying marginal tax rates and are willing to shift income for the benefit of the group or (b) taxpayers operating in multiple jurisdictions with different marginal tax rates.

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 understanding the time value of money important for tax planning?

Taxes paid are cash outflows, and tax savings generated from tax deductions can be thought of as cash inflows. With this perspective, the timing of when a taxpayer pays tax on income or receives a tax deduction for an expenditure obviously affects the present value of the taxes paid (i.e., a cash outflow) or tax savings received (i.e., a cash inflow).

Explain how implicit taxes may limit the benefits of the conversion strategy.

The concept of implicit taxes suggests that the demand for tax advantaged activities increases the costs associated with these activities, thereby reducing the pretax returns of these activities and the advantages of the conversion strategy. For example, implicit taxes may reduce or eliminate the advantages of tax-preferred investments (e.g., municipal bonds, or investments taxed at preferential tax rates) by decreasing the pretax rate of returns for these investments.

In this chapter we discussed three basic tax planning strategies. What different features of taxation does each of these strategies exploit?

The timing strategy exploits the variation in taxation across time - i.e., the "real" tax costs of income decrease as taxation is deferred; the "real" tax savings associated with tax deductions increase as tax deductions are accelerated. The income shifting strategy exploits the variation in taxation across taxpayers. Finally, the conversion strategy exploits the variation in taxation across activities.

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).

What are the two basic timing strategies? What is the intent of each?

The two strategies are deferring taxable income and accelerating tax deductions. The intent of deferring taxable income recognition is to minimize the present value of taxes paid. The intent of accelerating tax deductions is to maximize the present value of tax savings from the deductions.

Describe the three parties engaged in every business transaction and how understanding taxes may aid in structuring transactions.

There are three parties involved in virtually every transaction: the taxpayer, the other transacting party, and the government (i.e., the uninvited silent party that specifies the tax consequences of the transaction). Effective tax planning requires an understanding of the tax and nontax costs from the taxpayer's and other party's perspectives because tax and nontax factors also influence the other party's preferences. Understanding these preferences will allow the taxpayer to identify an optimal transaction structure.

What is needed to implement the conversion strategy?

To implement the conversion strategy, one must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment.

What is the key factor in shifting income from a business to its owners? What are some methods of shifting income in this context?

To shift income from the corporation to the owner, the transaction must generate a tax deduction to the corporation. Compensation paid to employee-owners is the most common method of shifting income from corporations to their owners. Compensation expense is deductible by the corporation and is generally taxable to the employee. Having the business owner rent property to the corporation or loan money to the corporation are also effective income shifting methods, because both transactions generate tax deductions for the corporation and income for the shareholder. Because corporations do not get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Instead, paying dividends results in "double taxation"—the profits generating the dividends are taxed first at the corporate level, and then the dividends are taxed at the shareholder level.

How do changing tax rates affect the timing strategy? What information do you need to determine the appropriate timing strategy when tax rates change?

When tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions will now vary. The higher the tax rate, the higher the tax savings for a tax deduction. The lower the tax rate, the lower the tax costs for taxable income. All things being equal, taxpayers should prefer to recognize deductions during high-tax-rate years and income during low-tax-rate years. The implication is that before a taxpayer implements the timing strategies (accelerate deductions, defer income), she should consider whether her tax rates are likely to change. Increasing tax rates may actually result in taxpayers preferring to accelerate income and defer deductions. To determine the appropriate timing strategy when tax rates change, you need the taxpayer's after-tax rate of return and the amount of the tax rate increase.