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Principles of Taxation. Chapter 4 Basic Maxims of Income Tax Planning. 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. Tax Avoidance.

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Principles of Taxation

Chapter 4 Basic Maxims of Income Tax Planning


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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


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Tax Avoidance

  • Avoidance is legal

  • Tax evasion is a federal crime

  • 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, but will permit a discussion of ethics and evasion as well. Just as we hope (and trust? - or monitor?) that you do not cheat in class, we expect that you will not evade taxes as future businessmen and women.


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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.


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Income Tax Planning - Entity

  • Individual taxpayers

    • have a progressive tax rate structure that ranges from 15 percent to 39.6 percent

    • see the inside front cover of text. Work AP2

  • Corporate taxpayers

    • have a progressive tax rate structure that ranges from 15 percent to 35 percent for richest corporations.

    • see the corporate tax rates in text. Marginal rates of 38% and 39% eliminate benefits of lower brackets. Work AP1


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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 establish a new business, consider the tax rates paid by the form of business entity.

    • See chapter 11. flow-through versus corporation

  • What about established business entities? Reducing tax liabilities may depend on:

    • Income Shifting

    • Deduction Shifting


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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. Work AP5

  • Deduction Shifting

    • Arranging transactions for the purpose of transferring deductions from a low tax rate entity to a high tax rate entity. Work AP4

  • Assignment of Income Doctrine prohibits shifting of income from property UNLESS the property is transferred also. See AP3


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Income Tax Planning - Time

  • Because federal and state taxing authorities impose a tax on income only once a year, the tax paid or tax savings from any transaction depends on the year the transaction occurs.

  • 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


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Income Tax Planning - Time

  • Opportunity Costs

    • Shifting tax liabilities to a later period also 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.

  • 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.


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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 OK

  • b) Taxpayer can delay $100 income and tax both by one year.

    • PV of after-tax value of $70 x 0.909 = $64 WORSE

  • 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 $92 BEST


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Income Tax Planning - Time and Tax Rate Changes

  • Suppose in c), Congress changes the tax law to increase the tax rate to 35%.

  • Then, the PV of pre-tax income is still $99.

  • However, PV of tax cost is

    • ($35) x .909 = ($32).

  • Net = $67 WORSE.

  • See also AP8, 9.


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Income Tax Planning - Jurisdiction

  • The Jurisdiction variable has become increasingly important because: state laws differ and country laws differ.

  • Much more opportunity for related-party tax planning.

  • Tax Costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate.


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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 the parent prefer to charge the sub? (Note - most countries have laws requiring ‘arms’ length’ prices.)

    • For discussion: IR2. See also Chapter 12.


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Income Tax Planning - Income Character

  • Ordinary income is generated by the routine operations of a business or investment activity. This includes service income, sales, interest, dividends, royalties, and rents. Ordinary income is subject to tax at regular tax rates.

  • Capital income is generated by the sale of capital assets (see chapter 7 definition). Capital income has consistently been subject to lower tax rates than ordinary income. (e.g. 20% for individuals)


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Income Tax Planning - Income Character

  • Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character.

  • Because one form of income receives preferential tax rates, taxpayers are continually trying to arrange transactions to convert ordinary income into capital income. The Tax Code contains dozens of provisions that prohibit the artificial conversion of ordinary to capital income.


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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.


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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.

    • Easiest example is municipal bonds: If taxable bonds are yielding 10%, and if the top tax bracket is 40%, then municipal bonds will yield about 6%, because rich taxpayers will buy municipals as long as the interest rate is at least 6%. If not enough rich taxpayers demand municipal bonds, the rates may be slightly higher.

    • See AP10


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Tax Law Doctrines - IRS calls foul

  • 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 are presumed to be independent.


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