1. Chapter 4 Maxims of Income Tax Planning McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Objectives Differentiate between tax avoidance and tax evasion
List the four variables that determine the tax consequences of a transaction
Explain why an income shift or a deduction shift can improve NPV
Explain how the assignment of income doctrine constrains income-shifting strategies
Distinguish between an explicit tax and an implicit tax

3. Objectives (continued)
Contrast the tax character of ordinary income and capital gain
Distinguish between an explicit and implicit tax
Summarize the four tax planning maxims
Describe the legal doctrines that the IRS uses to challenge tax planning strategies

4. Tax Avoidance
Tax avoidance consists of legitimate means of reducing taxes
Tax evasion consists of illegal means of reducing taxes
Felony offense punishable by severe monetary fines and imprisonment

5. Tax Planning Variables
Tax consequences of a transaction depend on the interaction of four variables
Entity variable: Which entity undertakes the transaction?
Time period variable: In which tax year does the transaction occur?
Jurisdiction variable: In which taxing jurisdiction does the transaction occur?
Character variable: What is the tax character of the income, gain, loss, or deduction from the transaction?

6. 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

7. Income Tax Planning - Entity
Individual taxpayers
Progressive tax rate structure
ranging from 10% to 39.6%
Corporate taxpayers
ranging from 15% to 39%
Both sets of rate schedules are included in Appendix C

8. Tax Rates
Compute 2014 tax, marginal rate, and average rate on $250,000 income if:
Taxpayer is a single individual
Taxpayer is a corporation
Answer:
$66,358 ($45, [$250,000 – $186,350]) 33% marginal rate; 26.54% average rate
$80,750 ($22, [$250,000 – $100,000]) 39% marginal rate; 32.3% average rate

9. 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 type of business entity
See Chapter 12: passthrough entity versus corporation

10. 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

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

12. 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

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

14. Income Tax Planning – Time Period Variable
Tax rate increase
If taxpayers defer the recognition of 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

15. 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])

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

17. 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 low tax rate jurisdiction
The jurisdiction variable is discussed in Chapter 13

18. Income Tax Planning – Character Variable
Tax character of income is determined by law
Every income item is characterized as either ordinary income or capital gain
Ordinary income is generated from sale of goods or performance of services in 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)

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

20. 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

21. Conflicting Tax Planning Maxims
Sometimes, the four tax planning maxims conflict!
For example, a transaction defers tax may shift income to an entity with a higher tax rate
Managers should remember that their strategic goal is not tax minimization but NPV maximization

22. Implicit Taxes
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%
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

23. Tax Law Doctrines IRS can use legal doctrines
to challenge a tax planning strategy
Economic substance/business purpose doctrine A transaction must have a business purpose other than tax avoidance
Codified in §7701(o)
Substance over form doctrine IRS can look through legal formalities to determine economic substance
Step transaction doctrine IRS can collapse a series of interdependent transactions into one transaction