Chapter 3: Tax Planning Strategies and Related Limitations Flashcards
What three parties are involved in tax transactions?
The taxpayer, the other transacting party (employer) and the government (silent party who specifies the tax consequences of the transaction)
What is the goal of effective tax planning?
maximizing the taxpayer’s after tax wealth while achieving the taxpayer’s nontax goals
What are the three building blocks of tax planning?
Timing
Income shifting
Conversion
What is a discount factor?
A factor based on the taxpayer’s rate of return that is used to determine the present value of future cash inflows (tax savings) and outflows (taxes paid)
What is the present value of money?
PV= FV / (1 + r)^n
the concept that $1 today is worth more than $1 in the future.
FV= PV x (1 + r)^n
when considering cash inflows, higher present values are preferred
when considering cash outflows, lower present values are preferred
What is the general rule of thumb that financial planners always keep mind?
When considering cash inflows, prefer higher present values
When considering cash outflows, prefer lower present values
What is a discount factor?
a factor that is very useful for calculating the present value of future inflows or outflows of cash. This factor is derived from the taxpayer’s expected after-tax rate of return
What are the two basic tax-related timing strategies when tax rates are constant?
Accelerate tax deductions (deduct in an earlier period)
Defer recognizing taxable income (recognize in a later period)
What is the general idea of accelerate tax deductions?
tax savings received now have a higher present value than the same amount received a year from now. The intent of the timing strategy is to accelerate the tax deduction significantly without accelerating the actual cash outflow that generates the expense
What is the general idea of Deferring taxable income?
Taxes paid a year from now have a lower present value than taxes paid today?
When tax rates change what should the timing strategy be?
When tax rates are higher, savings for a tax deduction is higher. Meaning that you want to find more deductions to decrease income when taxes are high. The lower the tax rate, the lower the tax costs for taxable income
What are the limitations of timing strategies?
Timing strategies to defer income or accelerate deductions is less beneficial if the acceleration of a deduction also accelerates cash outflow.
That income must be recognized when earned
Tax laws require tax payers to continue investments in an asset in order to defer income recognition for tax purposes.
What is the constructive receipt doctrine?
The judicial doctrine that states a taxpayer must recognize income when it is actually or constructively received. This doctrine is deemed to have occurred if the income has been credited to the taxpayer’s account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability and there are not restrictions on the taxpayer’s control over the income
What is the assignment of income doctrine?
The judicial doctrine holding that earned income is taxed to the taxpayer providing the service, and that income from property is taxed to the individual who owns the property when the income accrues
What is a related party transaction?
financial activities among family members, among owners and their businesses, or among businesses owned by the same owners
What are arm’s length transactions?
transactions among unrelated taxpayers, where each transacting party negotiates for his or her own benefit
What is the Income shifting strategy?
Income shifting exploits the differences in tax rates across taxpayers or jurisdictions.
Examples of income shifting transactions are high tax rate parents shifting income to lower tax rate children.
The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns the income
What is the conversion strategy?
Based on the understanding that the tax law does not treat all types of income or deductions the same
To implement the conversion strategy one must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment
What are two examples of the conversion strategy?
Investment planning that exploits the advatages of investing in assets that generate prefentially taxed income and compensation planning that restructures employee compensation from currently taxable compensation to nontaxable or tax deferred forms of compensation, such as employer provided health insurance and retirement contributions
What is the business purpose doctrine?
This judicial doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation
What is the Step-transaction doctrine?
The judicial doctrine that allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction
What is the economic substance doctrine?
The judicial doctrine that requires transactions to meaningfully change taxpayer’s economic position and to have a substantial purpose (apart from a federal income tax purpose) in order for a taxpayer to obtain tax benefits
What is tax avoidance?
The legal act of arranging one’s transactions or affairs to reduce taxes paid.
What is tax evasion?
The willful attempt to defraud the government. Tax evasion falls outside the confines of legal tax avoidance
When does tax avoidance become tax evasion?
In order to determine if a transaction is avoidance or evasion professional judgement, the use of a smell test and consideration of the business purpose, step-transaction, and substance-over-form doctrines may prove useful
What is the constructive receipt doctrine?
A taxpayer must recognize income when it is actually or constructively received. This has occurred if the income has been credited to the taxpayer’s account of if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income
