Tax Ch 3

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% this year, he would have $_____ a year from now. He should take the $_____.

$1,872, $1,800 FV = 1,800 x (1+0.04)^1 = 1,872

before-tax rate of return

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

2 most important considerations that are necessary for effective tax planning for individuals

*Maximizing after-tax wealth *Achieving non-tax related goals

Three basic tax planning strategies

*Timing *Income Shifting *Conversion

Timing strategy most beneficial

*When tax deductions can be accelerated without accelerating the cash outflow *When the transaction is large *When the taxpayer is earning a high rate of return *When tax rates are high

Which of the following options is a limitation of a timing strategy?

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

Under what circumstances might a taxpayer want to defer the recognition of income?

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

When is a timing strategy most beneficial?

-When tax deductions can be accelerated without accelerating the cash outflow -When tax rates are high -When the taxpayer is earning a high rate of return -When the transaction is large

Tax payers prefer...

-lower present values when considering cash outflows -higher present values when considering cash inflows

The discount factor for a one-year investment earning a rate of return of 3% is equal to __________. (Rounded to 3 decimal places)

0.971 (1/(1+0.03) = 0.971)

Assume Rafael can earn an 10 percent after-tax rate of return. Would he prefer $1,100 today or $1,650 in five years?

1,100 today (1,650 / (1 + 0.1)^5 = 1,024)

"high dividend" stock taxed at

15%

Qualified dividends and capital gains are taxed at ____ if not in very bottom and top of tax bracket.

15%

Darlene plans to purchase furniture for her office. The cost of the furniture is $3,000. She is currently in the 20% tax bracket so her after tax cost of the furniture is $_____ if she purchases it in December of the current year. She believes that her marginal rate will increase to 25% next year. If she waits until early January of next year to purchase the furniture and her after tax rate of return is 7%, the after-tax cost of her furniture is $_____ based on today's dollars.

2,400; 2,299 Present: $3,000 x 0.20 = 600; 3,000 - 600 = 2,400 Next Year: $3,000 x 0.25 = 750 x 0.935 (PV) = 701; 3,000 - 701 = 2,299

taxable corporate bonds taxed at

35%

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?

5,300 (5,000 x (1+0.06)^1 = 5,300)

Assuming a positive interest rate, the present value of money suggests: a. $1 today > $1 in one year b. $1 today <= $1 in one year c. $1 today = $1 in one year d. $1 today < $1 in one year

A

Which of the following TP would likely benefit LEAST from an income shifting strategy? a. TP with a business that operates in one state b. TP that has family members with varying marginal rates c. TP that operates businesses in different jurisdictions

A

Which of the following options best describes the basis for conversion strategies? a. The understanding that the tax law does not treat all types of income and deductions the same b. The understanding of tax laws in different jurisdictions in order to take advantage of the more favorable provisions c. The understanding that it is beneficial to accelerate deductions and defer income d. The understanding of how to effectively shift income among family members to best benefit the group

A

If Joel earns a 10% after-tax rate of return, $10,000 received in two years is worth how much today (round present and future value amounts to 3 places)? a. $8,260 b. $10,000 c. $9,090 d. $11,000 e. None of these

A ($10,000 / (1 + 0.1)^2)

transfer pricing

A number of possibilities exist to execute a strategy such as King Acura's in Example 3-10. Assuming that the North Dakota and South Dakota locations exchange cars, the firm could shift income via ___ ___ (using the price the South Dakota location charges the North Dakota location for cars transferred to North Dakota).

Under which of the following situations is a timing strategy most beneficial? (Choose all that apply) a. When tax rates are high b. When tax deductions can be accelerated without accelerated the cash outflow c. When tax rates are low d. When TP is earning a high rate of return e. When TP is expecting to be taxed at a higher rate in the future f. When the transaction is large g. When the transaction is small

A, B, D, F

Which of the following statements are CORRECT? (Choose all that apply) a. TP prefer higher present values when considering cash inflows b. TP prefer lower present values when considering cash inflows c. TP prefer lower present values when considering cash outflows d. TP prefer higher present values when considering cash outflows

A, C

Which of the following are tax planning methods used in income shifting strategies? (Choose all that apply) a. Moving income and deduction to more tax favorable jurisdictions b. Changing the form of income into a more tax-favored type of income c. Accelerating deductions into an earlier year d. Moving income from TP in one rate bracket to TP in a different rate

A, D

judicial, business motivation, collapse, substance

ADDITIONAL LIMITATIONS TO TAX PLANNING STRATEGIES: JUDICIAL DOCTRINES Certain ___ doctrines restrict the common tax planning strategies (timing, income shifting, and conversion). The business purpose doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying ___ ___. The step-transaction doctrine allows the IRS to ___ a series of related transactions into one transaction to determine the tax consequences of the transaction. The substance-over-form doctrine allows the IRS to reclassify a transaction according to its ___.

When tax rates are decreasing, TP should __________ tax deductions and ___________ taxable income.

Accelerate, defer

Timing

Accelerating tax deductions and deferring the recognition of taxable income

Business purpose doctrine

Allows the IRS to challenge and disallow business expenses with no underlying business motivation.

Step-transaction doctrine

Allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences.

Substance over form doctrine

Allows the IRS to consider the purpose of the transaction regardless of the way it is structured

In order for related-party transactions to be acceptable to the IRS, they should be structured as an

Arm's length transaction

Effective tax planning does not require consideration of: a. nontax factors. b. None of these. c. the other party's tax costs of alternative transactions d. the taxpayer's tax costs of alternative transactions e. the other party's nontax costs of alternative transactions

B

How should a TP evaluate whether it is advantageous to accelerate a tax deduction in a period of tax rate increases? a. TP needs to compare the tax-savings at the current tax rate to the tax-savings at the projected rate b. TP needs to compare tax-savings from the deduction in the current year to the PV of the tax-savings in one year c. TP should always choose to take the deduction in the high-tax-rate year if there is an option d. TP needs to compare the future value of the tax-savings in the current year

B

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

B

Danny is trying to determine if he should purchase equipment of this business this year or next year. He is currently in the 28% tax bracket and will be able to expense the equipment in the year he purchases it. With the new equipment, he believes that his marginal rate will increase to 33% next year. The cost of the equipment is $20,000 and his after-tax rate of return is 6%. Calculate the after-tax cost of the equipment for both years and choose the correct statement below. a. The after-tax cost of the equipment is $14,400 this year or $13,400 next year. Danny should purchase the equipment this year. b. The after-tax cost of the equipment is $14,400 this year or $13,776 next year. Danny should purchase the equipment next year. c. The after-tax cost of the equipment is $14,400 this year or $13,400 next year. Danny should purchase the equipment next year. d. The after-tax cost of the equipment is $14,400 this year or $13,776 next year. Danny should purchase the equipment this year.

B Present Year: $20,000 x 0.28 = 5,600; 20,000 - 5,600 = $14,400 Next Year: $20,000 x 0.33 = $6,600 x 0.943 (PV) = 6,224; 20,000 - 6,224 = $13,776 $14,400 > $13,776 --> Next year because it is cheaper

Under what circumstances might a TP want to defer the recognition of income? (Choose all that apply) a. When the TP expects to be in a higher tax bracket in the future. b. When setting aside money for retirement. 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 decline

B, C

Which of the following options is a limitation of a timing strategy? (Choose all that apply) a. The assignment of income doctrine dictates that the person/entity earning the income cannot assign the income and tax consequences to another. b. Tax laws generally require TP to continue their investment in an asset in order to defer income recognition. c. TP can sometimes choose to accelerate recognition of tax deductible expense. d. Constructive receipt doctrine often prevents income from being deferred to a later period.

B, D

shift

Because corporations don't get a tax deduction for dividends paid, paying dividends is not an effective way to ___ income

When considering the timing of transactions, what tax planning strategy should be used for tax deductions if tax rates are constant?

Because tax deductions result in tax savings, they should be deducted in an earlier period (accelerated) when possible.

Allows the IRS to challenge and disallow business expenses with no underlying business motivation

Business purpose doctrine

Andrew received 20% of his business revenue in cash. The cash was not third-party reported to the IRS. Andrew has decided NOT to report the cash receipts on his tax return. Which response is true? a. Failure to report the income is acceptable since it is not being reported to the government by third parties. b. Failure to report the income is a form of a conversion strategy. c. Failure to report the income is considered tax evasion. d. Failure to report the income is considered tax avoidance.

C

Limitations on certain tax benefits, such as depreciation for luxury automobiles, often decrease or eliminate the benefits of __________ strategies. a. Timing b. Diversion c. Conversion d. Income shifting

C

Which is not a basic tax planning strategy? a. conversion b. timing c. arms length transaction d. None of these e. income shifting

C

Which of the following choices is INCORRECT when referring to income shifting strategies across jurisdictions? a. Although tax laws may be more favorable in other countries, negative publicity may hamper operations of companies who move operations overseas. b. The IRS is likely to closely scrutinize companies who operate in multiple jurisdictions c. TP that operate in multiple countries should incorporate in the country with the lowest tax structure in order to pay taxes in that country d. The differences in tax rates and tax laws across jurisdictions can often be used to maximize after-tax wealth

C

Which of the following is NOT necessarily a party of effective tax planning? a. Achieving non tax goals b. Maximizing after-tax wealth c. Minimizing tax payments

C

Which of the following methods will NOT result in a tax beneficial shift of income from a corporation to its employee-owner? a. Paying compensation to the employee-owner b. Renting property from the employee-owner c. Paying dividend to the employee-owner d. Borrowing money from the employee-owner

C

Entity is taxed seperate from individual and no employment taxes

C corporation

Choose the two most important considerations from the following list that are necessary for effective tax planning for individuals? a. Minimizing taxes b. Maximizing government revenue c. Maximizing after-tax wealth d. Achieving non-tax related goals

C, D

Conversion

Changing the type of income to a more tax-favored form of income

The __________ doctrine is a limitation of a timing strategy because it often restricts the income deferral for cash-method taxpayers.

Constructive receipt

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

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?

Conversion Strategy

In addition to accelerating deductions, the timing strategy of __________ income recognition is beneficial to many taxpayers. a. Accelerating b. Converting c. Eliminating d. Deferring

D

If Rudy has a 25% tax rate and a 6% after-tax rate of return, a $30,000 tax deduction in four years will save how much tax in today's dollars (round present and future value amounts to 3 places)? a. $7,500 b. $28,290 c. $30,000 d. $5,940

D ($30,000 x 0.25 = 7,500 / (1+0.06)^4 = 5,943)

Lucky Lee has won a contest where he can choose to receive $500 today or $550 one year from now. Assuming his rate of return is 5%, how much is the $550 worth today? a. $500.00 b. $550.00 c. $577.73 d. $523.60

D ($550 x 0.952 (PV) = $523.60)

Calculate the discount factor for one period for an investment given a rate of return equal to 6%. a. 0.167 b. 0.060 c. 1.06 d. 0.943

D (1/(1+0.06) = 0.943)

All other things being equal, taxpayers should prefer to recognize __________during high-tax rate years and ___________during low-tax rate years.

Deductions during high-tax Income during low-tax

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

Deferring

Requires the transaction to meet two criteria: (1) meaningfully change a taxpayers economic position and (2) have a substantial purpose for the transaction

Economic substance doctrine

tax borders, related, jurisdictions

First, taxing authorities are fully aware of the tax benefits of strategically structuring transactions across ___ ___ (across countries or states). Thus, the IRS closely examines transfer pricing on international transactions. Similarly, state tax authorities scrutinize interstate transactions between ___ taxpayers. Second, when taxpayers locate in low-tax-rate ___ to, in effect, shift income to a tax-advantaged jurisdiction, they may bear implicit taxes (i.e., additional costs attributable to the jurisdiction's tax advantage).

A lower rate of return on a 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

jurisdictions, shifting, assignment of income, family

LO 4: Apply the strategy of income shifting, provide examples, and describe its limitations. • The income-shifting strategy exploits the differences in tax rates across taxpayers or ___. Three of the most common examples of income shifting are high-tax-rate parents ___ income to low-tax-rate children, businesses shifting income to their owners, and taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions. • The ___ ___ ___ doctrine requires income to be taxed to the taxpayer who actually earns the income. In addition, the IRS closely monitors such related-party transactions— that is, financial activities among ___ members, among owners and their businesses, or among businesses owned by the same owners. Implicit taxes may also limit the benefits of income shifting via locating in tax-advantaged jurisdictions.

same, conversion, investment, compensation, nature

LO 5: Apply the conversion strategy, provide examples, and describe its limitations. • Tax law does not treat all types of income or deductions the ___. This understanding forms the basis for the conversion strategy— recasting income and expenses to receive the most favorable tax treatment. To implement the ___ 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. • Common examples of the conversion strategy include ___ planning to invest in assets that generate preferentially taxed income, ___ planning to restructure employee compensation from currently taxable compensation to nontaxable or taxdeferred forms of compensation, and corporate distribution planning to structure corporate distributions to receive the most advantageous tax treatment. • The Internal Revenue Code contains specific provisions that prevent the taxpayer from changing the ___ of expenses, income, or activities to a more tax-advantaged status. Implicit taxes may also reduce or eliminate the advantages of conversion strategies.

business purpose, step-transaction, substance-over-form, economic substance

LO 6: Describe basic judicial doctrines that limit tax planning strategies. • The ___ ___ doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation, such as a travel cost of a spouse accompanying a taxpayer on a business trip. • The ___ ___ doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction. • The ___ ___ ___ 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 codified ___ ___ doctrine requires transactions to have a substantial purpose and to meaningfully change a taxpayer's economic position in order for a taxpayer to obtain tax benefits.

constructive receipt, credited, unconditionally available, assignment of income, wide variety

LO 6: Describe basic judicial doctrines that limit tax planning strategies. • The ___ ___ doctrine, which may limit the timing strategy, provides that a taxpayer must recognize income when it is actually or constructively received1; Constructive receipt is deemed to have occurred if the income has been ___ to the taxpayer's account or if the income is ___ ___ 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. • The ___ ___ ___ doctrine requires income to be taxed to the taxpayer who actually earns the income. The assignment of income doctrine implies that, in order to shift income to a taxpayer, that taxpayer must actually earn the income. • The business purpose, step-transaction, and substance-over-form doctrines apply across a ___ ___ of transactions and planning strategies (timing, income shifting, and conversion).

legal, evasion, smell test

LO 7: Contrast tax avoidance and tax evasion. • Tax avoidance is the ___ act of arranging one's transactions, and so on, to minimize taxes paid. Tax ___ is 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. • In many cases a clear distinction exists between avoidance (e.g., not paying tax on municipal bond interest) and evasion (e.g., not paying tax on a $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 "___ ___," and consideration of the business purpose, step-transaction, and substance-over-form doctrines may prove useful.

maximizes, nontax, same, taxes, taxpayer, government, tax planning

LO1: Identify the objectives of basic tax planning strategies. • Effective tax planning ___ the taxpayer's after-tax wealth while achieving the taxpayer's ___ goals. Maximizing after-tax wealth is not necessarily the ___ 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 (i.e., ___). • Virtually every transaction involves three parties: the ___, the other transacting party, and the uninvited silent party that specifies the tax consequences of the transaction (i.e., the ___). Astute ___ ___ requires an understanding of the tax and nontax costs from the taxpayer's and the other party's perspectives.

timing, present value, vary, defer, accelerate

LO2: Apply the timing strategy and describe its applications and limitations. • One of the cornerstones of basic tax planning involves the idea of ___— that is, when income is taxed or an expense is deducted affects the associated "real" tax costs or savings. This is true for two reasons. First, the timing of when income is taxed or an expense is deducted affects the ___ ___ of the taxes paid on income or tax savings on deductions. Second, the tax costs of income and tax savings income ___ as tax rates change. • When tax rates are constant, tax planners prefer to ___ income (i.e., to reduce the present value of taxes paid) and ___ deductions (i.e., to increase the present value of tax savings). Higher tax rates, higher rates of return, larger transaction amounts, and the ability to accelerate deductions or defer income by two or more years increase the benefits of the timing strategy.

vary, change, increasing, decreasing, accelerate, defer, less, constructive receipt

LO2: Apply the timing strategy and describe its applications and limitations.+ • When tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions ___ as tax rates change. When tax rates are ___, the taxpayer must calculate the optimal tax strategies for deductions and income. When tax rates are ___, the recommendations are clear. Taxpayers should ___ tax deductions into earlier years and ___ taxable income to later years. • Timing strategies contain several inherent limitations. Generally speaking, whenever a taxpayer must accelerate a cash outflow to accelerate a deduction, the timing strategy will be ___ beneficial. Tax law generally requires taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes. 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, and so on. The ___ ___ doctrine, which provides that a taxpayer must recognize income when it is actually or constructively received, also restricts income deferral for cash-method taxpayers.

time value, worth more, inflow, outflow

LO3: Apply the concept of present value to tax planning • The concept of present value— also known as the ___ ___ of money— basically states that $1 today is ___ ___ than $1 in the future. For example, assuming an investor can earn a positive return (e.g., 5 percent after taxes), $1 invested today should be worth $1.05 in one year. Hence, $1 today is equivalent to $1.05 in one year. • The implication of the time value of money for tax planning is that the timing of a cash ___ or a cash ___ affects the present value of the income or expense.

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

Low, high

Allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences

Step transaction doctrine

Allows the IRS to consider the purpose of the transaction regardless of the way it is structured

Substance over form doctrine

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

More

Income shifting

Moving income and deductions from taxpayers in one tax bracket to taxpayers in a different tax bracket.

Income shifting tax planning strategy

Moving income to more tax favorable jurisdictions

Concept that 1$ today is worth more than 1$ tomorrow is known as:

Present Value

Economic substance doctrine

Requires the transaction to meet 2 criteria: 1) meaningfully change a taxpayer's economic position 2) Have a substantial purpose for the transaction

The impact of the __________ rate level on a transaction must be considered along with the __________ value of the transaction to determine if the benefits of accelerating the transaction outweigh the disadvantages.

Tax, present

avoidance, evasion

TAX EVASION VERSUS TAX AVOIDANCE Tax ___ is the legal act of arranging one's transactions to minimize taxes paid. Tax ___ is the willful attempt to defraud the government by not paying taxes legally owed. Tax evasion falls outside the confines of legal tax avoidance.

the same, implicit

THE CONVERSION STRATEGY The conversion strategy is based on the understanding that the tax law does not treat all types of income or deductions ___ ___ 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. The Internal Revenue Code contains specific provisions that prevent the taxpayer from changing the nature of expenses, income, or activities to a more tax- advantaged status. ___ taxes may also reduce or eliminate the advantages of conversion strategies.

taxpayers, jurisdictions, shifting, assignment of income, related

THE INCOME-SHIFTING STRATEGY Income shifting exploits the differences in tax rates across ___ or ___. Common examples of income ___ include high-tax-rate parents shifting income to low-tax-rate children, businesses shifting income to their owners, and taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions. The ___ ___ ___ doctrine requires income to be taxed to the taxpayer who actually earns the income. The IRS also closely monitors income-shifting strategies that involve ___-party transactions.

taxpayers, jurisdictions

Tax rates can also vary across ___ or ___ (states, countries), which leads to still other tax planning strategies—for example, shifting income from high-tax-rate taxpayers to low-tax-rate taxpayers or shifting deductions from low-tax-rate taxpayers to high-tax-rate taxpayers.

Every transaction includes three parties: the __________, the other transacting party, and the ___________.

Taxpayer, government

substance-over-form

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

assignment of income

The ___ ___ ___ doctrine requires income to be taxed to the taxpayer who actually earns it

step-transaction

The ___ ___ doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction.

business purpose

The ___ ___ doctrine, for instance, allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation, such as the travel cost of a spouse accompanying a taxpayer on a business trip

related parties, jurisdictions

The type of taxpayers who benefit most from this strategy are (1) ___ ___, 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; and (2) taxpayers operating in multiple ___ with different marginal tax rates.

after-tax return = before-tax return x (1 - Marginal tax rate)

To analyze the benefits of the conversion strategy, you often compare the after-tax returns of alternative investments rather than the before-tax rate of returns. Given a stationary marginal tax rate, you can calculate an investment's after-tax rate of return as follows:

arm's-length

Unlike ___ ___ transactions, where each transacting party negotiates for his or her own benefit, related-party transactions involve taxpayers who are much more willing to negotiate for their own common good to the detriment of the IRS

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

Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December, she received a $17,000 bill from her accountant for consulting services related to her small business. Reese can pay the $17,000 bill anytime before January 30 of next year without penalty. Assume Reese's marginal tax rate is 30 percent this year and will be 40 percent next year, and that she can earn an after-tax rate of return of 11 percent on her investments. a. What is the after-tax cost if she pays the $17,000 bill in December? b. What is the after-tax cost if she pays the $17,000 bill in January? c. Based on requirement a and b, should Reese pay the $17,000 bill in December or January?

a. $11,900 (17,000 x 0.30 = 5,100; 17,000 - 5,100 = 11,900) b. $10,873 (17,000 x 0.40 = 6,800; 6,800 x 0.901 = 6,127; 17,000 - 6,127 = 10,873) c. January

Hyundai is considering opening a plant in two neighboring states. Option 1: One state has a corporate tax rate of 10 percent. If operated in this state, the plant is expected to generate $940,000 pretax profit. Option 2: The other state has a corporate tax rate of 2 percent. If operated in this state, the plant is expected to generate $900,000 of pretax profit. a. What is the after state taxes profit in the state with the 10% tax rate? b. What is the after state taxes profit in the state with the 2% tax rate? c. Which state should Hyundai choose?

a. $846,000 (940,000 x 0.10 = 94,000; 940,000 - 94,000 = 846,000) b. $882,000 (900,000 x 0.02 = 18,000; 900,000 - 18,000 = 882,000) c. Option 2

Match the three basic tax planning strategies with their description: i. Timing ii. Income Shifting iii. Conversion a. Accelerating tax deductions and deferring the recognition of taxable income. b. Moving income and deductions from taxpayers in one tax bracket to taxpayers in a different tax bracket. c. Changing the type of income to a more tax-favored form of income.

a. i b. ii c. iii

Andy is considering investing $5,000 into one of three investments. He can invest in corporate stock that will pay dividends of 5% per year. He can purchase corporate bonds that pay 6%. Or, he can invest in tax-exempt securities that will pay 4% per year. Andy is in the 33% marginal tax bracket and the dividends will be taxed at 15%. Match the investment to its respective after-tax return. i. Corporate stock ii. Corporate bonds iii. Tax-exempt securities a. $212.50 b. $201.00 c. $200.00

a. i ($5,000 x 0.05 x (1-0.15)) b. ii ($5,000 x 0.06 x (1-0.33)) c. iii ($5,000 x 0.04)

Match the judicial doctrine used by the IRS when taxpayer abuse is suspected with the description of the doctrine. i. Business purpose doctrine ii. Step-transaction doctrine iii. Substance over form doctrine iv. Economic substance doctrine a. Requires transaction to meet two criteria: (1) meaningfully change a TP economic position and (2) have substantial purpose for the transaction b. Allows IRS to challenge and disallow business expenses with no underlying business motivation c. Allows IRS to collapse a series of related transactions into one transaction to determine tax consequences d. Allows IRS to consider purpose of transaction regardless of the way it is structured

a. iv b. i c. ii d. iii

after tax return =

after tax return = before tax return - (before tax return x marginal tax rate)

The ____ doctrine is a limitation of a timing strategy because it often restricts the income deferral for cash-method taxpayers.

constructive receipts

Limitations on certain tax benefits, such as depreciation for luxury automobiles, often decrease or eliminate the benefits of ____ strategies.

conversion

When tax rates are constant of _____, taxpayers should accelerate tax deductions and defer taxable income.

decreasing

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.

deduction income

All other things being equal, taxpayers should prefer to recognize _____ during high tax-rate years and ____ during low tax rate years.

deductions Income

economic substance doctrine

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

Taxed at corporate level with dividends

double taxation

______ planning maximizes the taxpayers after tax wealth while achieving the taxpayers nontax goals.

efffective tax planning

related-party transactions

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

implicit taxes

indirect taxes that result from a tax advantage the government grants ta 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

After tax return rate

interest rate x (1 - tax rate)

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

If a capital asset is held for more than a year, it is recognized as_____.

long term capital gain

PV= FV/ (1+r)^n

present value formulat to calculate discount factor

A flow through taxed at individual level, you can pay dividends and not get double taxed

s corporation & partnerships

Although municipal bonds are not taxed at federal level, some can be taxed at the ____ level.

state

Municipal bonds are always....

tax exempt

present value

the concept that $1 today is worth more than $1 in the future. for example, assuming an investor can earn a 5% after tax return. $1 invested today should be $1.05 in one year

discount factor

the factor based on the taxpayer's rate of return that is used to determine the present value of future cash flows (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

business purpose doctrine

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

constructive receipt doctrine

the judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received. 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

How should a taxpayer evaluate whether it is advantageous to accelerate a tax deduction in a period of tax rate increases?

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.

tax evasion

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

arm's length transactions

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