Ch.3 Questions & Problems

What factors increase the benefits of accelerating deductions

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

The goal of tax planning is to minimize taxes." Explain why this statement is not true.

In general terms, 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).

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.

Duff is really interested in decreasing his tax liability, and by his very nature he is somewhat aggressive. A friend of a friend told him that cash transactions are more difficult for the IRS to identify and, thus, tax. Duff is contemplating using this "strategy" of not reporting cash collected in his business to minimize his tax liability. Is this tax planning? What are the risks with this strategy?

Not tax planning. This is tax evasion. Risks include monetary penalties & imprisonment

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 the assignment of income doctrine. In what situations would this doctrine potentially apply?

The assignment of income doctrine requires income to be taxed to the taxpayer that actually earns the income. Merely assigning income (e.g., someone's paycheck or dividend) to another taxpayer does not transfer the tax liability associated with the income. The implication of the assignment of income doctrine is that to shift income to a taxpayer (i.e., to employ the shifting strategy), the taxpayer must actually earn the income.

Tesha works for a company that pays a year-end bonus in January of each year (instead of December of the preceding year) to allow employees to defer the bonus income. Assume Congress recently passed tax legislation that decreases individual tax rates as of next year. Does this increase or decrease the benefits of the bonus deferral this year? What if Congress passed legislation that increased tax rates next year? Should Tesha ask the company to change its policy this year? What additional information do you need to answer this question?

The decrease in the tax rates increases the benefits of the bonus deferral. If Congress instead passed a tax rate increase, the benefit of the deferral may be reduced or eliminated. To determine if Tena should request the company to change its policy this year, you need to know the amount of the tax rate increase, and Tesha's after-tax rate of return

What is an "implicit tax"

The price of tax-advantaged assets like municipal bonds is bid up in competitive markets relative to the price of similar assets, like corporate bonds, without tax advantages. The higher price paid for tax-advantaged assets reduces the rate of return on these assets relative to other similar assets without tax advantages. This difference in rates of return represents an "implicit tax" on tax-advantaged assets.

What are the rewards of tax avoidance? What are the rewards of tax evasion?

The rewards of tax avoidance include maximizing the taxpayer's wealth. The rewards of tax evasion include civil and criminal penalties, including large monetary fines and sentencing to federal prison.

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.

Billups, a physician and cash-method taxpayer, is new to the concept of tax planning and recently learned of the timing strategy. To implement the timing strategy, Billups plans to establish a new policy that allows all his clients to wait two years to pay their co-pays. Assume that Billups does not expect his marginal tax rates to change. What is wrong with his strategy?

This plan will reduce the present value of taxes paid on the co-pays and the present value of the co-pays. The decrease in the present value of the co-pays will exceed the decrease in the present value of the tax paid on the co-pays. By delaying payment, Billups may increase the likelihood that many of his clients will not pay their co-pays

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 would be tax planning, so there are no risks or penalties

What factors increase the benefits of deferring income?

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.