Presentation on theme: "Variables that Create Tax Planning Opportunities"— Presentation transcript:
1 Variables that Create Tax Planning Opportunities ACC 2460 – Chapter 4Variables that Create Tax Planning OpportunitiesEntity variableTime period variableJurisdiction variableCharacter variableCaveat: We will discuss manipulation of these variables while first assuming equivalent before-tax cash flows and no differential non-tax costs
2 Important Differences in Taxation of Business Entities ACC 2460 – Chapter 4Important Differences in Taxation of Business EntitiesWhich of the following are ‘taxable entities’ and which are ‘conduit entities’?IndividualsC CorporationsS CorporationsPartnershipsLimited Liability CompaniesTrusts and Estates
3 Important Differences continued ACC 2460 – Chapter 4Important Differences continuedC corporationsIncome subject to double taxationIncome taxed to entity when earnedA dividend distribution of after-tax earnings is taxed again to shareholders when paidConduit entitiesIncome not taxed at the entity levelTaxed to owners when earned by the entity, regardless of whether any of such earnings are distributedDistributions of earnings to owners are not taxed
4 Entity Variable continued ACC 2460 – Chapter 4Entity Variable continuedMaxim: Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rateConstraints on income/deduction shifting strategies:Usually have to shift before-tax cash flow in order to shift tax costAssignment of income doctrine
5 In-Class Problem: Tax Planning and the Entity Variable ACC 2460 – Chapter 4In-Class Problem: Tax Planning and the Entity VariableJoe is planning to invest $100,000 in a small business venture expected to generate a 10% before-tax return on investment. Given his other sources of income, Joe’s marginal tax rate is 38.6%.Joe is considering incorporating his new business to take advantage of the lower marginal tax rate available to the new corporation.
6 In-Class Problem continued ACC 2460 – Chapter 4In-Class Problem continuedUnder each alternative:Compute Joe’s after-tax cash flow in the first year.If Joe reinvests the after-tax earnings of the business each year, and the investment continues to earn a 10% before-tax return, compute the accumulated value after 5 years.If Joe liquidates the business in 5 years, compute his total after-tax earnings, assuming that:If the investment is made personally, no additional tax is due on liquidationIf the investment is made through the corporation, Joe is taxed on the liquidated value in excess of his original investment
7 ACC 2460 – Chapter 4Time Period VariableMaxim: In present value terms, tax costs decrease (cash flows increase) when tax liability is deferred until a later taxable yearOptimal use of this strategy may require that tax liability be deferred without deferring pre-tax cash flows, unless other factors vary across time periods
8 ACC 2460 – Chapter 4In-Class ProblemMallory is a self-employed consultant and uses the cash basis of accounting for tax purposes. Mallory is negotiating with a new client on the timing of payment for a lengthy project estimated to cost $50,000. She is considering requesting payment of 1/2 of her fee now and 1/2 in one year when the project is complete, versus receiving the entire fee next year.
9 In-Class Problem continued ACC 2460 – Chapter 4In-Class Problem continuedUsing a 10% discount rate, compute Mallory’s after-tax cash flow from each alternative assuming a 38.6% marginal tax rate for both years.If Mallory qualified to use the completed-contract method of accounting (so that all income from the project would be taxed when completed) how would your answers to question 1 change?How would your answers to question 1 change if Mallory’s marginal tax rate is only 27% next year?
10 Jurisdiction Variable ACC 2460 – Chapter 4Jurisdiction VariableMaxim: Tax costs decrease (cash flows increase) when income is generated in a jurisdiction with a low tax rateExamples: differential tax rates across state and local taxing jurisdictions, differential tax rates from foreign versus U.S. business operations
11 ACC 2460 – Chapter 4Character VariableMaxim: Tax costs decrease (cash flows increase) when income is taxed at a preferential rate because of its characterExamples:Gains realized by individuals on the sale of investment assets (capital gains) are taxed at a maximum 15% tax rateInterest earned on municipal bonds is taxed at a preferential tax rate of zero
12 In-class Problem: Capital Gains Taxation ACC 2460 – Chapter 4In-class Problem: Capital Gains TaxationCandace sold an investment asset for $100,000, producing a capital gain of $20,000. Calculate Candace’s after-tax cash flow from the sale under each of the following scenarios:Candace’s marginal tax rate on ordinary income is 38.6% and the gain is long-termCandace’s marginal tax rate on ordinary income is 38.6% and the gain is short-termCandace’s marginal tax rate on ordinary income is 15%Candace is a corporation (Candace Inc.) with a marginal tax rate of 34%
13 Important Tax Doctrines ACC 2460 – Chapter 4Important Tax DoctrinesBusiness purpose - other than tax avoidanceSubstance over form - taxability of transaction determined by economic reality rather than (perhaps contrived) appearanceStep-transaction - allows the IRS to collapse a series of interdependent transactions into a single transaction to determine the ultimate tax result
14 Example: Business Purpose Doctrine ACC 2460 – Chapter 4Example: Business Purpose DoctrineIn the landmark case of Gregory vs. Helvering, the taxpayer created, reorganized and liquidated a corporation all within 6 days for the sole purpose of changing ordinary income (dividend) into capital gain. The subsequent dispute with the IRS was ultimately heard by the Supreme Court, who held that the formation and liquidation of the corporation “was in fact an elaborate and devious form of conveyance masquerading as a corporation reorganization” with no business purpose other than saving taxes. In disregarding the transaction, the court stated that “to hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”
15 Example: Substance over Form ACC 2460 – Chapter 4Example: Substance over FormBill is the owner of Bill’s Sub Shop. In order to lower his taxable income from the shop, Bill ‘employs’ his 3-year-old daughter as a janitor at a salary of $200 per week.Does Bill’s employment of his daughter reflect economic reality?Should Bill be allowed to deduct the salary paid to his daughter?What if Bill’s daughter were 15 and worked 20 hours per week in the sub shop?