Chapter 3. Rich Corporation Case. Howard Godfrey, Ph.D., CPA Professor of Accounting ©Howard Godfrey-2015

Common Tax Planning Techniques 1. Defer income to a future year. Delay tax payment (time value of money). (Lower tax rate in future year?] [First Connect H/W problem and second one.] 2. Move income to another entity. Incorporate business. Have current income taxed at corporate level, rather than at the individual level. [Third Connect H/W problem.] 3. Transfer income to relative in a lower bracket. (a)Give rental property or other investments to a relative who is in a lower tax bracket. (b)Give appreciated property to a child (in lower bracket). Child sells property and reports the gain.

Common Tax Planning Techniques 4. Replace ordinary income with long-term capital gains. Hold property longer than one year before selling. (Long-term capital gain rates.) 5. Invest in a dividend-paying stock instead of investing in a corporate bond. (Dividends are taxed at the preferential rates applicable to long-term capital gains.) 6. Invest in a municipal bond rather corp. bond (Municipal bond interest income is not subject to federal income tax, and is often not subject to state income tax.) [Fourth Connect H/W problem.]

Common Tax Planning Techniques 7. Shift income to another jurisdiction, such as a “low-tax” state, or a “low-tax” country. Coca-Cola is moving from Atlanta (U.S. top corp. rate: 35%) to the United Kingdom (top corporate rate: 20%). 8. Manage losses (capital losses & net operating losses). Avoid allowing losses to disappear before taking advantage of them. Play the “tax rates game.” Get the lowest tax rate. End goal is to maximize after-tax income, even if that means investing in a more profitable investment that also has a higher tax burden.

In summary, We try to reduce the tax rate or reduce the tax base. Buy a $500 computer on sale for $400, you save $100. You also reduce the tax base for the sales tax computation. You save sales tax of $8.00, if the sales tax rate is 8%. We may also reduce the tax rate. The State often has a sales tax holiday in August, for those buying back to school supplies. The tax rate goes to zero. You pay no sales tax. So, here you reduce the tax rate. Save taxes by reducing the tax base or the rate.

You need money to buy a house. You are in a low tax bracket. Your “top tax bracket” grandparents have land (held LT). They will sell it and give you the after-tax proceeds. Selling price (value)$300,000 Cost basis (to compute gain) $200,000 Profit$100,000 Their tax base for computing their income tax is $100,000 They pay 20% of $100,000 or $20,000. You receive $280,000.

Continue. They give you the property and you sell it. Selling price (value)$300,000 Cost basis (same as their basis) $200,000 Profit$100,000 Your tax base for computing the income tax is $100,000 You pay 15% of $100,000 or $15,000. You keep $285,000. That is better than getting $280,000

Continue. You inherit the property and you sell it. Selling price (value)$300,000 Cost basis (FMV at date of death) $300,000 Profit $0 Your base for computing income tax is $0 You pay 15% of $0 or $0. You keep $300,000. There is a higher “tax basis for computing gain,” and a lower basis for computing tax.

1.Mr. Rich invested $120,000 in Rich Corp. 2.Bought equipment for $30, Collected revenue of $400, Paid salaries of $200, Paid payroll taxes of $15,300 6.Paid other expenses of $74, Recorded depreciation on equipment, S/L method, 3-year useful life, zero estimated salvage value. 8.Recorded federal corporate income tax liability. There is no state income tax.

Note in the following slide that we assume: 1. Use GAAP depreciation expense on the tax return. 2.Operations continue at the same level in 2016 and Law does no change after Please review the next slide

Now, we can consider the impact of choosing to expense the entire cost of the equipment in That will help us in 2015, because the extra depreciation of $20,000 will reduce taxable income and reduce the amount of taxes payable for But our equipment will be fully depreciated for tax purposes. No depreciation can be claimed in 2016 and 2017

Remember, we continue to use straight-line depreciation in our audited financial statements. It is the tax return that has accelerated depreciation.

Compare with earlier journal entry

What accounts change from Case 1 to Case 2?

Note what happens to tax rates when you push income into the future years?

Note in the preceding slide that moving taxable income from 2015 to later years, results in a change in the marginal tax rate from 34% (for savings) to 39% (more future taxes).

In next slides, we see how taxable income at corporate level – - that is subject to income tax – is changed, as we shift income to the individual return where the individual pays tax on the additional income. With S corporation, Corp. pays no tax and owner pays tax on all of the income.

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