Chapter 3 Review
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 E. None of the Above
A. 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 items is illegal under the tax law? A. Tax avoidance B. Tax evasion C. Accelerating deductions D. Deferring income E. All of the above are legal
B. Tax evasion is illegal and may land the perpetrator within the confines of a federal prison.
Which of the following is an example of the conversion strategy? A. Accelerated 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 E. None of the above
C. 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 minimizing E. None of the above
C. 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.
If Rachel has a 40% tax rate and a 10% after-tax rate of return, a $100,000 tax deduction in one year will save how much tax in today's dollars (rounded)? A. $100,000 B. $40,000 C. $37,040 D. $36,360 E. None of the above
D. $100,000 x 40% x .909 (Discount factor, 10%, 1 year) = $36,360
Assume that Bill's marginal tax rate is 40%. If corporate bonds pay 10% interest, what interest rate would a municipal bond have to offer for Bill to be indifferent between the two bonds? A. 10% B. 16.67% C. 8% D. 6% E. None of the Above
D. 10% x (1-40%) = 6%
Which of the following strategies exploits the fact that tax rates vary by activity (income type)? A. Timing B. Present Value C. Income Shifting D. Conversion E. Evasion
D. The conversion strategy is based on the fact 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 15%), and still other forms of income like nontaxable compensation benefits and municipal bond interest are tax-exempt
If Jack earns an 8% after-tax rate of return, $10,000 received in three years is worth how much today (rounded)? A. $10,000 B. $11,664 C. $9,260 D. $8,570 E. $7,940
E. $10,000 x .794 (Discount Factor, 3 years, 8%) = $7,940
"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 non-tax 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 non-tax costs and benefits of alternative transactions, whereas tax minimization focuses solely on a single cost.
Bendetta, a high-tax-rate taxpayer, owns several rental properties and would like to shift some income to her daughter, Jenine. Bendetta instructs her tennants 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.
Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 40% this year and next year, and that she can earn an after-tax rate of return of 12% on her investments. When should she pay the $20,000 bill - this year or next?
Option 1: Pay $20,000 bill in December: $20,000 tax deduction x 40% marginal tax rate = $8,000 in present value tax savings After-tax cost = Pretax cost - Present Value Tax Savings = $20,000 - $8,000 = $12,000 Option 2: Pay $20,000 bill in January: $20,000 x 40% = $8,000 Present Value of Tax savings = $8,000 x .893 (Discount factor, 1 year, 12%) = $7, 144 After-tax cost = Pretax cost - Present value tax savings = $20,000 - $7,144 = $12,856 Paying the $20,000 in December is the clear winner. Accelerating her payment from January to December will increase the present value of the cash outflow by a few days. Thus, there is a minor present value cost associated with accelerating her payment.
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 and evasion. In other cases, the line between tax avoidance ad 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.
Describe the business purpose, step-transaction, and substance-over-form doctrines. What types of tax planning strategies may these doctrine inhibit?
The business purpose doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation. The step-transaction doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction. Finally, the substance-over-form doctrine allows the IRS to consider the transaction's substance regardless of its form, and where appropriate, reclassify the transaction according to its substance. The IRS uses these doctrines where they expect taxpayer abuse. They can be used to void income shifting, conversion, and timing strategies.
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 his strategy?
This is not tax planning. Instead, this strategy is tax evasion. The rewards of tax evasion include stiff monetary penalties and imprisonment.
Using the facts form 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.
