1. #4-1 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 4 Basic Maxims of Income Tax Planning

2. #4-2 Objectives Tax avoidance versus tax evasion Tax planning variables The Entity The Time Period The Jurisdiction The Character of Income Explicit and implicit taxes Tax law doctrines

3. #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. #4-4 Tax Avoidance This course teaches tax planning (avoidance), not evasion. Your questions like: ‘The IRS can’t find this type of income, can they?’ are interesting from a compliance standpoint, as well as an ethical standpoint. Just as we hope that you do not cheat in class, we expect that you will not evade taxes as future businessmen and women.

5. #4-5 Tax Planning Variables The tax consequences of a transaction depend on the interaction of 4 variables common to all transactions: 1.The entity variable: Which entity undertakes the transaction? 2.The time period variable: During which tax year does the transaction occur? 3.The jurisdiction variable: In which taxing jurisdiction does the transaction occur? 4.The character variable: What is the tax character of the income from the transaction?

6. #4-6 Income Tax Planning - Entity Generally, taxable income is computed the same for different entities. However, the amount of tax paid depends on the difference in tax rates across entities. The two primary tax paying entities’ are: corporations and individuals.

7. #4-7 Income Tax Planning - Entity Individual taxpayers have a progressive tax rate structure that ranges from 10% to 35% see the inside front cover of text. Corporate taxpayers have a progressive tax rate structure that ranges from 15% to 39%. see the corporate tax rates in text. Marginal rates of 38% and 39% eliminate benefits of lower brackets.

8. #4-8 Tax Rates What is the tax liability, the marginal tax rate, and average tax rate for $250,000 of taxable income, assuming: 1)The taxpayer is a single individual? 2)The taxpayer is a corporation? Answer: 1)$69,790 ($35,717 +.33 (250,000 – 146,750); 33% marginal; 28% average 2)$80,750 ($22,250 +.39 (250,000 – 100,000); 35% marginal; 32% average

9. #4-9 Income Tax Planning - Entity 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 form of business entity. See chapter 11; flow-through versus corporation

10. #4-10 Income Tax Planning - Entity What about established business entities? Reducing tax liabilities may depend on: Income Shifting Deduction Shifting

11. #4-11 Income Tax Planning - Entity Income Shifting Arranging transactions for the purpose of transferring income from a high tax rate entity to a low tax rate entity. Deduction Shifting Arranging transactions for the purpose of transferring deductions from a low tax rate entity to a high tax rate entity. After either an income or deduction shift, the parties in the aggregate are financially better off by the tax savings from the transaction.

12. #4-12 Income Tax Planning - Entity Constraints on Income Shifting Assignment of Income Doctrine – Income must be taxed to the entity that renders the service. Assignment of Income Doctrine prohibits shifting of income from property UNLESS the property is transferred also.

13. #4-13 Income Tax Planning - Time In present value terms, tax costs decrease (and cash flows increase) when a tax liability is deferred until a later taxable year. Limited by: Opportunity Costs Tax Rate Changes

14. #4-14 Income Tax Planning - Time Income Deferral and Opportunity Costs Shifting tax liabilities to a later period may entail shifting income to a later period. Thus, the opportunity costs of shifting the income may be greater than the tax savings associated with the liability deferral. The opportunity cost is the loss of the use of the after-tax cash flow in the current year.

15. #4-15 Income Tax Planning - Time Income Deferral and Tax Rate Changes If taxpayers defer a tax liability to a future date and Congress increases tax rates the benefits of the deferral may be lost or substantially limited. The risk that deferred income will be taxed at a higher rate escalates with the length of the deferral period.

16. #4-16 Income Tax Planning - Time & Opportunity Costs Assume that a taxpayer has a tax rate of 30 percent and a 10% discount rate. Compare the following: a) Taxpayer can receive $100 income and pay tax now.  After-tax value = $70 b) Taxpayer can delay $100 income and tax both by one year.  PV of after-tax value of $70 x 0.909 = $64 c) Taxpayer can delay $100 income by one month but delay tax effect by one year.  PV of pre-tax value = $100 x 0.99 = $99  PV of tax cost = ($30) x.909 = ($27). Net $72

17. #4-17 Income Tax Planning - Time and Tax Rate Changes Suppose in c), Congress changes the tax law to increase the tax rate to 35%. The PV of pre-tax income is still $99. However, PV of tax cost is ($35) x.909 = ($32) Net = $67

18. #4-18 Income Tax Planning - Jurisdiction The Jurisdiction variable is important because state & local tax laws differ and country tax laws differ. Tax Costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate.

19. #4-19 Income Tax Planning - Jurisdiction Multinational example: U.S. Parent company faces a 35% tax rate. Subsidiary in Japan faces a 50% tax rate. U.S. manufactures a product for $100 and Japanese subsidiary packages it and markets it for $200. Packaging and marketing costs are $10. What price would the parent prefer to charge the sub? (Note - most countries have laws requiring ‘arms’ length’ prices.) More discussion on this in Chapter 12.

20. #4-20 Income Tax Planning - Character The tax character of any item of income is determined strictly by law. Every item of income is characterized as either ordinary income or capital gain.  Ordinary income is generated by the routine operations of a business or investment activity and is subject to tax at regular tax rates. This includes service income, sales, interest, dividends, royalties, and rents.

21. #4-21 Income Tax Planning - Character Capital income is generated by the sale of capital assets (see chapter 7) and has consistently been subject to lower tax rates than ordinary income. (e.g. 15% for individuals) Some income is nontaxable. E.g.: Municipal bond income, many fringe benefits.

22. #4-22 Income Tax Planning - Character Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character.. Because some forms of income are taxed at preferential tax rates, taxpayers are continually trying to arrange transactions to convert ordinary income into capital income or nontaxable income. The Tax Code contains dozens of provisions that prohibit the artificial conversion of ordinary to capital income.

23. #4-23 Income Tax Planning Summary Entity, Time, Jurisdiction, Character Sometimes these planning maxims conflict e.g., defer tax to a later period but at a higher tax rate - must compute NPV to evaluate. Managers should remember that their strategic goal is not tax minimization per se but NPV maximization.

24. #4-24 Implicit Taxes The reduction in rate of return that a taxpayer receives because the market has bid up the price of a tax-favored asset is referred to as an implicit tax. Easiest example is municipal bonds: If taxable bonds are yielding 10% and the top tax bracket is 40%, then municipal bonds will yield about 6%. Taxpayers will buy municipals as long as the interest rate is at least 6%. If not enough taxpayers demand municipal bonds, the effective rates may be slightly higher.

25. #4-25 Tax Law Doctrines for IRS Challenges The are three tax law doctrines that the IRS can use to challenge a tax planning strategy. Business Purpose Doctrine - must have a business purpose other than tax avoidance. Substance Over Form Doctrine - IRS can look through legal formalities to determine economic substance. Step Transaction Doctrine - IRS can collapse a series of transactions into one. Rule of thumb - transactions more than a year apart are presumed to be independent.

26. #4-26