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Tax Planning

Tax Planning. Taxes: When you care enough to send the very least. Phoenix tax maven on AOL Income tax returns are the most imaginative fiction being written today Herman Wouk. Objective of Tax Planning. What is the fundamental objective of tax planning?. IRS Examiner.

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Tax Planning

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  1. Tax Planning Taxes: When you care enough to send the very least. • Phoenix tax maven on AOL Income tax returns are the most imaginative fiction being written today • Herman Wouk

  2. Objective of Tax Planning What is the fundamental objective of tax planning? IRS Examiner

  3. Objective of Tax Planning Goal of tax planning is to maximize the after-tax present value of wealth Goal is not to minimize taxes. Describe the most effectivetax minimization strategy.

  4. Tax Avoidance a. Will get you time in the slammer b. Is sound business strategy

  5. Tax Evasion and Tax Avoidance Tax Evasion is Illegal Tax Avoidance is Good Business

  6. Key Elements of Tax Planning • Tax Deferral • Tax Shifting Across Entities • Tax Shifting Across Time Periods Pay taxes at the latest date, in the lowest bracket entity and time period

  7. Tax Deferral • Deferring taxes increases the amount of cash which can be profitably reinvested in the business • PV of tax bill is lower • $1 tax tomorrow < $1 tax today • Deferral allows money to be profitably reinvested in the business • Fringe benefits provide some of the best deferral opportunities

  8. Fringe Benefits • Fringe benefits offer special deferral opportunity • Tax-free fringes (e.g., health insurance) • Long-term deferral (e.g., retirement plans) • Limitations • Benefits must usually be offered to all full-time employees • Retirement plans have maximum contribution limitations • Plans can be structured to maximize owner’s proportion of contributions

  9. Tax Deferral Question • You have $10,000 to invest in the stock market. Would you buy individual stocks, or a mutual fund? • You have $200,000 to invest in the stock market. Would you buy individual stocks, or mutual funds?

  10. Tax Deferral Question You have $10,000 to invest in the stock market. Would you buy individual stocks, or a mutual fund? Mutual fund for diversification purposes

  11. Tax Deferral Question You have $200,000 to invest in the stock market. Would you buy individual stocks, or mutual funds? Individual stocks for tax deferral • Avoid ordinary income treatment • Can defer gains indefinitely • Transfers as charitable contribution, gift or in estate on a tax-preferred basis

  12. IRAs • Roth IRA • Contribution not deductible • Earnings are not taxed • Withdrawals are not taxed • Regular IRA • Contribution deductible • Earnings are not taxed • Withdrawals are taxed Under most scenarios, a Roth IRA is preferred to a regular IRA

  13. Recommendation • Immediately start funding a Roth IRA • Use 401(k) plans to extent possible

  14. Deferral Strategies • Deferring income • Cash basis taxpayer avoids taxes on receivables • Billings/deposits at year-end may be delayed • Accelerate deductions • Pay expenses prior to year-end

  15. Special Deferral Opportunities • Fixed Assets • Depreciation methods • Sec. 179 expense • Bad Debts • LIFO Inventory

  16. Fixed Assets • Section 179 Expense • Up to $18,500 of fixed asset purchases can be expensed in one year (increases to $25,000 by 2003) • Spreading out purchases is preferable to bunching • Accelerated depreciation • Fixed assets can be depreciated using accelerated methods for tax, straight-line for books

  17. Sec. 179 Expense Asset Life Amount Automobile 5 $15,000 Computer 5 10,000 Office Equip 7 20,000 Which should be expensed under Sec. 179?

  18. Sec. 179 Expense Asset Life Amount Automobile 5 $15,000 Computer 5 10,000 Office Equip 7 20,000 Expense asset with longest life

  19. Timing of Fixed Asset Purchases Sec. 179 is an annual limitation Ex. Planning $30,000 of new fixed asset purchases • Buy $18,500 in December this year • Buy rest in January of following year Allows use of Sec. 179 in 2 years

  20. LIFO Inventory(Last-In, First-Out) • LIFO inventory reduces taxes when inventory prices are rising • Must also be used for financial statements (FIFO usually disclosed) • Provides additional deferral timing option • Taxes can be affected by timing of inventory purchases

  21. LIFO Inventory • LIFO Pitfalls • Write-offs for obsolescence not allowed • Unplanned inventory liquidation can result in large tax bill by including old, “cheap” inventory in cost of goods sold

  22. Tax Shifting Across Periods • Closely related to strategies of deferral and entity is shifting across periods to take advantages of differences in rates • Especially for relatively low levels of income, smooth income patterns are preferred due to increases in marginal rates • Changes in tax law represent special planning opportunities

  23. Changes in Tax Rates 90% Ordinary income 70% 50% 30% Capital gains 1967 1980 1990 1997

  24. Income Smoothing Example Corp. A Corp. B Income Taxes Income Taxes Year 1 100,000 22,250 50,000 7,500 Year 2 0 0 50,000 7,500 Total 100,000 22,250 100,000 15,000

  25. Shifting Across Entities • Effective tax planning considers the marginal tax rate of all parties to the transaction • Company and shareholder • Buyer and seller of a business

  26. Tax Shifting to Owner • Primary form of tax shifting is through the timing of compensation payments to owner • Shift income to shareholder if shareholder is in lower bracket • Payroll taxes need to be considered • Compensation should be documented and justified

  27. Other Planning Opportunities • Organizational form • Capital structure (debt vs. equity) • Asset ownership • Compensation of Family Members • Independent Contractors

  28. Debt vs. Equity C corporation should generally be capitalized with minimal equity • Interest payments are tax-deductible (assuming entity is profitable) • Tax-advantage compared to salary since not subject to payroll tax • Loan can be repaid tax-free • Loan should be documented • Overall debt-equity ratio is reasonable

  29. Compensation for Family Members • Paying compensation to other family members can reduce overall taxes • Shift to family members in lower brackets • Provide retirement and other fringes • Pitfalls • Compensation must be “reasonable” • Possible adverse effects on business • Income producing property, such as real estate, can also be transferred to family members

  30. Independent Contractor Advantages: • No employer payroll tax • No employer-paid fringe benefits Which is the key advantage?

  31. Independent Contractor Advantages: • No employer payroll tax • No employer-paid fringe benefits No fringe benefits is key advantage • Payroll taxes are paid by contractor, presumably part of compensation • Fringes may be more costly

  32. Independent Contractor Pitfall - Reclassification as employee • Most litigated area in tax code • Employer can be held responsible for both employer and employee payroll taxes

  33. Contractor vs. Employee • IRS relies upon 20 factor test • Basic criteria - Do you control employee’s actions? • Who schedules the work • Where is the work performed • Who supplies the tools • Does the employee/contractor work for others

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