McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 4 Maxims of Income Tax Planning McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

4-2Objectives  Explain the difference between tax avoidance and tax evasion  Describe the four tax planning variables  Entity variable  Time period variable  Jurisdiction variable  Character variable  Compute an explicit and implicit tax  Describe the major tax law doctrines

4-3 Tax Avoidance  Tax avoidance consists of legitimate means of reducing taxes  Tax evasion consists of illegal means of reducing taxes and is a felony offense punishable by severe monetary fines and imprisonment

4-4 Tax Planning Variables  Tax consequences of a transaction depend on the interaction of four variables  The entity variable: Which entity undertakes the transaction?  The time period variable: In which tax year does the transaction occur?  The jurisdiction variable: In which taxing jurisdiction does the transaction occur?  The character variable: What is the tax character of the income from the transaction?

4-5 Income Tax Planning - Entity  Generally, taxable income is computed under the same rules across business entities  However, the tax on business income depends on the difference in tax rates across entities  The two taxpaying business entities are individuals and corporations

4-6 Income Tax Planning - Entity  Individual taxpayers  Have a progressive tax rate structure ranging from 10% to 35%  Corporate taxpayers  Have a progressive tax rate structure ranging from 15% to 39%  Both sets of rates are printed on the inside front cover of the text

4-7 Tax Rates  What is the 2008 tax, marginal rate, and average rate on $250,000 taxable income if:  The taxpayer is a single individual?  The taxpayer is a corporation?  Answer:  $68,251 (40, [250,000 – 164,550]; 33% marginal rate; 27.30% average rate  $80,750 (22, (250,000 – 100,000); 39% marginal rate; 32.3% average rate

4-8 Income Tax Planning – Entity Variable  Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate  When establishing a new business, consider the tax rates paid by the type of business entity  See chapter 12: passthrough entity versus corporation

4-9 Income Tax Planning – Entity Variable  Income shifting  Arranging transactions to transfer income from a high tax rate entity to a low tax rate entity  Deduction shifting  Arranging transactions to transfer deductions from a low tax rate entity to a high tax rate entity  After an income or deduction shift, the parties in the aggregate are financially better off by the tax savings from the transaction

4-10 Income Tax Planning – Entity Variable  Assignment of income doctrine  Constraint on income shifting  Income must be taxed to the entity that earns it by the sale of goods or performance of services  Income generated by capital must be taxed to the entity that owns the capital

4-11 Income Tax Planning – Time Period Variable  In present value terms, tax costs decrease (and cash flows increase) when a tax cost is deferred until a later taxable year  Constrained by:  Opportunity costs  Tax rate increase

4-12 Income Tax Planning – Time Period Variable  Opportunity costs  Shifting tax costs to a later period may involve postponing a cash inflow to a later period. Thus, the opportunity cost of postponing the cash inflow may exceed the savings from the tax deferral  The opportunity cost is the loss of the immediate use of the cash

4-13 Income Tax Planning – Time Period Variable  Tax rate increase  If taxpayers defer the recognition of taxable income to a future year and Congress increases future tax rates, the cost of the rate increase offsets the benefit of the deferral  The risk that deferred income will be taxed at a higher rate increases with the length of the deferral period

4-14 Income Tax Planning - Opportunity Costs  Assume that a taxpayer has a 30% tax rate and uses a 10% discount rate. Compute NPV of the following:  Taxpayer receives $100 cash/income and pays tax now  NPV = $70  Taxpayer defers the receipt of cash/income by one year  NPV = $64 ($70 × 0.909)  Taxpayer receives $100 cash but defers recognizing income by one year  NPV = $73 ($100 – $27[$30 × 0.909])

4-15 Income Tax Planning - Tax Rate Increase  Taxpayer receives $100 cash but defers recognizing income by one year. However, Congress increases the tax rate from 30% to 40% next year  NPV = $64 ($100 – $36[$40 × 0.909])

4-16 Income Tax Planning – Jurisdiction Variable  The jurisdiction variable is important because local, state, and foreign tax laws differ  Tax costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate  The jurisdiction variable is discussed in Chapter 13

4-17 Income Tax Planning – Character Variable  The tax character of an income item is determined strictly by law  Every income item is characterized as either ordinary income or capital gain  Ordinary income is generated from the sale of goods or performance of services in the regular course of business  Income generated by investments (interest, dividends, royalties, and rents) is ordinary  Capital gains are generated by the sale or exchange of capital assets (defined in Chapter 8)

4-18 Income Tax Planning – Character Variable  Most types of ordinary income are taxed at regular rates  Exceptions to this rule include interest on state and local bonds (tax-exempt for both corporations and individuals) and qualified dividends (taxed at preferential rates for individuals)  Capital gains  Taxed at preferential rates for individuals  Taxed at regular rates for corporations

4-19 Income Tax Planning – Character Variable  Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character.  Because capital gains are taxed at preferential rates, individuals try to arrange transactions to convert ordinary income to capital gain  The Internal Revenue Code contains dozens of provisions that prevent the conversion of ordinary income to capital income

4-20 Conflicting Tax Planning Maxims  Sometimes, the four tax planning maxims conflict!  For example, a transaction that results in tax deferral may cause income to shift to an entity with a higher tax rate  Managers should remember that their strategic goal is not tax minimization per se but NPV maximization

4-21 Implicit Taxes  A reduced before-tax rate of return on a tax-favored investment is called an implicit tax  Example: A corporate bond pays 9% and a municipal bond pays 6.3%  An investor who purchases the municipal bond incurs a 30% implicit tax (2.7% reduced rate/9%)  Investors with marginal rates greater than 30% maximize their after-tax rate of return by purchasing the municipal bond  Investors with marginal rates less than 30% maximize their after-tax rate of return by purchasing the corporate bond

4-22 Tax Law Doctrines for IRS Challenges  The IRS can use three legal doctrines to challenge a tax planning strategy  Business purpose doctrine A transaction must have a business purpose other than tax avoidance  Substance over form doctrine The IRS can look through legal formalities to determine economic substance  Step transaction doctrine The IRS can collapse a series of interdependent transactions into one transaction

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