Chapter 4 - Maxims of Income Tax Planning

Question 1

What is Tax Planning?

Answer 1

The structuring of transactions to reduce tax costs or increase tax savings to maximize the NPV of the transaction.

Question 2

What are Income Tax Planning Maxims?

Answer 2

Basic principles that are the foundation for many planning techniques.

Question 3

What is Tax Avoidance?

Answer 3

Legitimate means to reducing taxes paid.

Question 4

What is Tax Evasion?

Answer 4

Illegal means to reduce taxes paid. It is a federal crime and punishable be severe monetary fines and imprisonment.

Question 5

When might the IRS think something is tax evasion as opposed to just tax avoidance?

Answer 5

When they perceive the taxpayer has crossed the line between a good faith effort to reduce taxes and a willful attempt to defraud the U.S. government.

Question 6

The tax consequences of a transaction depend on the interaction of which four variables common to all transactions?

Answer 6

1. The entity variable: Which entity undertakes the transaction?
2. The time period variable: During which tax year or years does the transaction occur?
3. The jurisdiction variable: In which tax jurisdiction does the transaction occur?
4. The character variable: What is the tax character of the income from the transaction.

Question 7

What two (general) entities pay tax on business income?

Answer 7

Individuals and corporations

Question 8

Why aren’t trusts and estates counted as entities that pay tax on business income?

Answer 8

While they are taxable entities, they don’t routinely engage in the active conduct of business.

Question 9

Who is the income taxed for for the following business types:
Proprietorship
Partnership
LLC
S corporation

Answer 9

• Proprietor
• Partners
• Members
• Shareholders.

Question 10

Generally, what does the amount of taxable income derived from a business activity not depend on?

Answer 10

The type of entity conducting the business.

Question 11

If the tax law is essentially neutral across entities with respect to tax base, why do the tax consequences of business transactions depend on which entity undertakes the transaction?

Answer 11

Because of the potential difference between applicable tax rates.

Question 12

What does Section 1 of the Internal Revenue Code provide?

Answer 12

The tax rate structure for individuals.

Question 13

How many income brackets are there in the tax rate structure for individuals?

Answer 13

Seven.

Question 14

What does Section 11 of the Internal Revenue Code provide?

Answer 14

The tax rate structure for corporations (completely different than those for individuals).

Question 15

What is the first income tax planning maxim?

Answer 15

Tax costs decrease (and cash flow increase) when income is generated by an entity subject to a low tax rate.

Question 16

Basically, what does that choice of organizational form determine in relation to taxes?

Answer 16

Whether the business income will be taxed a the individual rates or the corporate rates.

Question 17

What does the maxim of ‘Tax costs decrease (and cash flow increase) when income is generated by an entity subject to a low tax rate.’ imply?

Answer 17

That the tax on a business income can be reduced if that income is shifted from an entity with a high tax rate to an equity with a low tax rate. (Income Shifting)

Question 18

Besides income shifting, how else can entities with different marginal tax rates save tax?

Answer 18

Deduction Shifting - moving a deductible expense from a an entity with a low marginal tax rate to one with a higher marginal tax rate.

Question 19

Who does income shifting us usually occur between?

Answer 19

Because they involve transfers of value from one party to another they usually occur between related parties. After the income shift the parties in the aggregate are financially better off by the tax savings from the transaction.

Question 20

When might the IRS disallow a transaction between two related companies?

Answer 20

When the transaction serves no genuine purpose besides tax avoidance, thereby disallowing the tax consequences intended by the parties.

Question 21

What is the Supreme Court’s decision on who pays the taxes on an income?

Answer 21

The income must be taxed to the person who earns it, even if another person has a legal right to the wealth represented by the income (giving $10,000 income to kid to avoid the tax hit is not allowed)

Question 22

What is the Assignment of Income Doctrine?

Answer 22

Income must be taxed by the entity that renders the service or owns the capital with respect to which the income is paid.

Question 23

With regard to the time period variable, what does the tax costs of savings from a transaction depend upon?

Answer 23

The year in which the transaction occurs.

Question 24

How can people reduce their tax cost or increase the tax saving received in respect to time?

Answer 24

By controlling the timing of transactions.

Question 25

If the the marginal tax rates and the tax law were absolutely stable over time, why would the tax costs and savings from transactions still vary with the time period during which the transaction occurs?

Answer 25

Because of the time value of money. In present value terms a tax dollar paid this year cost more than a tax dollar paid in a future year. Conversely, a tax dollar saved this year is worth more than a tax dollar saved in the future.

Question 26

What is the second income tax planning maxim?

Answer 26

In present value terms, tax costs decrease (and cash flows increase) when a tax is deferred until a later year.

Question 27

When does the maxim ‘In present value terms, tax costs decrease (and cash flows increase) when a tax is deferred until a later year.’ hold true?

Answer 27

Only when a tax payment can be deferred independently of before-tax cash flows or when the value of the deferral exceeds any opportunity cost of a coinciding change in before-tax cash flows.

Question 28

Why might there be uncertainty with the deferral of taxable income into future years?

Answer 28

There may be uncertainty as to the marginal rate that will apply to that income.

Question 29

Why would a firm’s aggregate income tax liability (federal, state local, be a function of the jurisdictions in which it conducts business.

Answer 29

Because of the differences and state and local tax systems.

Question 30

For federal income tax purposes, how does the federal government treat state income tax payments?

Answer 30

It deducts them in the computation of taxable income

Question 31

What is the third income tax planning maxim?

Answer 31

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

Question 32

How is every item of income ultimately characterized for tax purposes?

Answer 32

Ordinary Income

Capital Gain

Question 33

What is Ordinary Income?

Answer 33

The income generated by the routine sales of goods or services to customers or clients. This also includes the yield on invested capital, such as interest, dividends, and rents.

Question 34

What is a Capital Gain?

Answer 34

The sale or exchange of certain types of property, referred to capital assets, gives rise to capital gain.

Question 35

What is the special characteristic that a municipal bond has?

Answer 35

Its income is taxed at a preferential rate of zero.

Question 36

What is the fourth tax planning maxim?

Answer 36

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

Question 37

What is the positive tax benefit difference due to when income is taxed at a preferential rate as opposed to a person’s regular marginal rate?

Answer 37

The difference between the regular marginal rate and the preferential rate when applied to the income receiving the benefit of the preferential rate.

Question 38

How have many taxpayers and their advisers normally heeded the fourth tax planning maxim?

Answer 38

By structuring transactions to result in capital gain rather than ordinary income.

Question 39

What has Congresses worked hard doing in response to the ingenious techniques sometimes used for converting potential ordinary income from a transaction to a capital gain? What does the Internal Revenue Code have to say about it?

Answer 39

• To protect the integrity of the distinction between the two types of income.
• The Code contains dozens of prohibitions against artificial conversion of ordinary income into capital gains.

Question 40

What is responsible for more complexity in the federal income tax system than any other feature?

Answer 40

The preferential treatment of capital gains.

Question 41

What should a decision to engage in a transaction generating income tax at a preferential rate be based upon?

Answer 41

The Net Present Value the transaction rather than the fact of the preferential rate.

Question 42

Why do many investors accept the lower rate of municipals bonds when compared to corporate bonds?

Answer 42

Because of the tax-favored status of the bonds.

Question 43

What is an Explicit Tax?

Answer 43

The actual tax liability paid directly to the taxing jurisdiction.

Question 44

What is an Implicit Tax?

Answer 44

The reduction in before-tax rate of return that investors are willing to accept because of the tax-favored characteristic of an investment.

Question 45

What is the threshold where a person would choose a taxable bond over a municipal bond?

Answer 45

When the implicit tax of the muni is greater than the explicit tax of the taxable bond.

Question 46

Why has Congress granted tax-exempt status to municipal bond interest?

Answer 46

To help state and local governments compete in the capital markets. The loss in revenues attributable to the tax preference represents an indirect federal subsidy to these governments.

Question 47

What two things determine whether a tax preference is worth anything to a given investor?

Answer 47

The investor’s marginal tax rate

Any implicit tax on the investment.

Question 48

What maxims are a result in analysis of the variables that determine the tax consequences of transactions? Name the four already asked.

Answer 48

• Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate.
• In present value terms, tax costs decrease (and cash flows increase) when a tax is deferred until a later taxable year.
• Tax costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate.
• Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character.

Question 49

When a tax strategy may adhere to one maxim but violate another, what must taxpayers do?

Answer 49

Carefully assess the overall tax consequences to determine if the strategy improves the NPV.

Question 50

When might a firm make a choice between two options of the option with a lesser tax benefit?

Answer 50

When the cost of implementing the strategy that provides the greater benefit makes the net value to the firm less than the simpler option of that produces the lesser tax benefit.

Question 51

Why must tax strategies be evaluated on the basis of flexibility?

Answer 51

So they strategy can have as much chance as possible to be adapted to any unforeseen circumstances. Very important is the assumptions in place about the future when the strategy was initially devised do not hold up to be true.

Question 52

What is every strategy’s anticipated effect on cash flows based upon?

Answer 52

Assumptions about the future.

Question 53

Even when a manager believes that their tax strategy is technically sounds, what must they still consider?

Answer 53

The government’s reaction to the overall propriety of the strategy.

Question 54

When would the IRS invoke the four important common law doctrines that have evolved in the tax planning area?

Answer 54

When they believe a firm seems to be bending the rules to gain an unjustified tax advantage.

Question 55

What is the Economic Substance Doctrine?

Answer 55

A transaction that doesn’t change the taxpayer’s economic situation except by the tax savings from the transaction should be disregarded for tax purposes.

Question 56

What is the Business Purpose Doctrine?

Answer 56

A transaction should not be effective for tax purposes unless it is intended to achieve a genuine and independent business purpose other than tax avoidance.

Question 57

What is the Substance Over Form Doctrine?

Answer 57

The IRS can look through legal formalities to determine the economic substance (if any) of a transaction and to base the tax consequences on the substance instead of the form.

Question 58

What is the Step Transaction Doctrine?

Answer 58

The IRS can collapse a series of intermediate transactions into a single transaction to determine the tax consequences of the arrangement in its entirety.

Question 59

According to the codified form of the first two common law doctrines that Congress enacted in Section 7701(o) of the Internal Revenue Code, when does a transaction have economic substance?

Answer 59

Only if it ‘changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction’. A transaction that is devoid of economic substance will not be respected for tax purposes.

Question 60

When does the IRS use the Step Transaction Doctrine?

Answer 60

When transactions are so obviously interdependent that the parties involved would not have initiated the first transaction without anticipating that the whole series of transactions would occur.

• Transactions occurring within a short period of time are more vulnerable to the step transaction doctrine than those occurring over a longer interval.
  
  • As a rule of thumb, the IRS considers transactions occurring within a 12-month period as suspect.
  • Transactions separated in time by more than 12 months are presumed to be independent.