# Variables that Create Tax Planning Opportunities

## Presentation on theme: "Variables that Create Tax Planning Opportunities"— Presentation transcript:

Variables that Create Tax Planning Opportunities
ACC 2460 – Chapter 4 Variables that Create Tax Planning Opportunities Entity variable Time period variable Jurisdiction variable Character variable Caveat: We will discuss manipulation of these variables while first assuming equivalent before-tax cash flows and no differential non-tax costs

Important Differences in Taxation of Business Entities
ACC 2460 – Chapter 4 Important Differences in Taxation of Business Entities Which of the following are ‘taxable entities’ and which are ‘conduit entities’? Individuals C Corporations S Corporations Partnerships Limited Liability Companies Trusts and Estates

Important Differences continued
ACC 2460 – Chapter 4 Important Differences continued C corporations Income subject to double taxation Income taxed to entity when earned A dividend distribution of after-tax earnings is taxed again to shareholders when paid Conduit entities Income not taxed at the entity level Taxed to owners when earned by the entity, regardless of whether any of such earnings are distributed Distributions of earnings to owners are not taxed

Entity Variable continued
ACC 2460 – Chapter 4 Entity Variable continued Maxim: Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate Constraints on income/deduction shifting strategies: Usually have to shift before-tax cash flow in order to shift tax cost Assignment of income doctrine

In-Class Problem: Tax Planning and the Entity Variable
ACC 2460 – Chapter 4 In-Class Problem: Tax Planning and the Entity Variable Joe 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.

In-Class Problem continued
ACC 2460 – Chapter 4 In-Class Problem continued Under 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 liquidation If the investment is made through the corporation, Joe is taxed on the liquidated value in excess of his original investment

ACC 2460 – Chapter 4 Time Period Variable Maxim: In present value terms, tax costs decrease (cash flows increase) when tax liability is deferred until a later taxable year Optimal use of this strategy may require that tax liability be deferred without deferring pre-tax cash flows, unless other factors vary across time periods

ACC 2460 – Chapter 4 In-Class Problem Mallory 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.

In-Class Problem continued
ACC 2460 – Chapter 4 In-Class Problem continued Using 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?

Jurisdiction Variable
ACC 2460 – Chapter 4 Jurisdiction Variable Maxim: Tax costs decrease (cash flows increase) when income is generated in a jurisdiction with a low tax rate Examples: differential tax rates across state and local taxing jurisdictions, differential tax rates from foreign versus U.S. business operations

ACC 2460 – Chapter 4 Character Variable Maxim: Tax costs decrease (cash flows increase) when income is taxed at a preferential rate because of its character Examples: Gains realized by individuals on the sale of investment assets (capital gains) are taxed at a maximum 15% tax rate Interest earned on municipal bonds is taxed at a preferential tax rate of zero

In-class Problem: Capital Gains Taxation
ACC 2460 – Chapter 4 In-class Problem: Capital Gains Taxation Candace 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-term Candace’s marginal tax rate on ordinary income is 38.6% and the gain is short-term Candace’s marginal tax rate on ordinary income is 15% Candace is a corporation (Candace Inc.) with a marginal tax rate of 34%

Important Tax Doctrines
ACC 2460 – Chapter 4 Important Tax Doctrines Business purpose - other than tax avoidance Substance over form - taxability of transaction determined by economic reality rather than (perhaps contrived) appearance Step-transaction - allows the IRS to collapse a series of interdependent transactions into a single transaction to determine the ultimate tax result