Upload
catherine-cunningham
View
249
Download
1
Tags:
Embed Size (px)
Citation preview
Chapter 4Chapter 4
Maxims of Income Maxims of Income Tax PlanningTax Planning
McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.
4-2
ObjectivesObjectives
• 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
4-3
Objectives (continued)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
4-4
Tax AvoidanceTax 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
4-5
Tax Planning VariablesTax 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?
4-6
Income Tax Planning - EntityIncome 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
4-7
Income Tax Planning - EntityIncome Tax Planning - Entity
• Individual taxpayers • Progressive tax rate structure
ranging from 10% to 39.6%
• Corporate taxpayers• Progressive tax rate structure
ranging from 15% to 39%
• Both sets of rate schedules are included in Appendix C
4-8
Tax RatesTax 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 ($45,354 + .33 [$250,000 – $186,350])
33% marginal rate; 26.54% average rate
• $80,750 ($22,250 + .39 [$250,000 – $100,000]) 39% marginal rate; 32.3% average rate
4-9
Income Tax Planning – Entity VariableIncome 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
4-10
Income Tax Planning – Entity VariableIncome 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
4-11
Income Tax Planning – Entity VariableIncome 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
4-12
Income Tax Planning – Time Period VariableIncome 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
4-13
Income Tax Planning – Time Period VariableIncome 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
4-14
Income Tax Planning – Time Period VariableIncome 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
4-15
Income Tax Planning - Opportunity CostsIncome 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])
4-16
Income Tax Planning - Tax Rate IncreaseIncome 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])
4-17
Income Tax Planning – Jurisdiction VariableIncome 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
4-18
Income Tax Planning – Character VariableIncome 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)
4-19
Income Tax Planning – Character VariableIncome 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
4-20
Income Tax Planning – Character VariableIncome 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
4-21
Conflicting Tax Planning MaximsConflicting 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
4-22
Implicit TaxesImplicit 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
4-23
Tax Law DoctrinesTax Law Doctrines
• IRS can use legal doctrinesto 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