Chapter 3 Notes
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This 7 page Class Notes was uploaded by Victoria Andreski on Sunday January 24, 2016. The Class Notes belongs to ACCT 404 at Clemson University taught by Sarah Martin in Spring 2016. Since its upload, it has received 22 views. For similar materials see Individual Taxation in Accounting at Clemson University.
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Date Created: 01/24/16
Chapter 3 : Tax Planning, Strategies, & Related Limitations • Effective planning requires considering tax AND non-tax factors o Maximizes taxpayer’s non-tax wealth while achieving taxpayer’s non-tax goals • 3 parties in every transaction: o 1. Taxpayer o 2. Other party o 3. Government • 3 basic planning strategies: o 1. Timing—deferring/accelerating taxable income & tax deductions o 2. Income shifting—shifting income from high to low rate taxpayers o 3. Conversion—converting income from high to low rate activities • Taxes can significantly affect costs/benefits associated w/ business, investment, & personal transactions • Nontax factors—financial goals & legal constraints • Maximizing after-tax wealth—recognize both tax & non-tax costs & benefits of alternative transactions • Tax minimization—focus on single cost of taxes • Good tax planning requires an understanding of tax & non-tax costs from taxpayers’ & other party’s perspective o Ex: employer’s compensation plans its employees must consider the ERs & EEs perspective Timing Strategies • When income is taxed or an expense is deducted, it affects the associated “real” tax costs/savings because: o 1. Time that income is taxed/expense is deducted affects the present value of the taxes paid on income/tax savings on deductions o 2. Tax cost of income & tax savings income vary as tax rates change § Tax rate changes come from job changes, getting married (joint tax rate), having children, buying a house, etc. • Present Value o $1 today is worth more than $1 in the future o Timing of cash inflow/outflow affects PV of income/expense o Cash inflows: Higher PV are preferred o Cash outflows: Lower PV are preferred • Example: Bob & Sarah purchased $1,000 worth of appliances with “no money down and no payments for one year!” How much money is this deal actually worth? Assume their after-tax rate of return on investments is 8%. o Discount rate is .926 (Time value table: 8% interest rate column, year 1 row) means the present value of $1,000 is $926 (1,000X .926= 926) so Bob & Sarah save $74 (1,000-926= 74) § They save $74 by paying in a year • Taxes paid= cash outflows • Tax savings generated from tax deductions= tax inflows • 2 tax-related timing strategies: o Accelerating deductions—accelerating a current cash inflow § Get tax savings sooner • Refund § Increase the PV of tax savings from the deductions § Tax savings received now have a higher PV than tax savings received a year from now o Deferring income—deferring a current cash outflow § Delaying tax payment § Decreases the PV of the tax cost of the income § Taxes paid a year from now have a lower PV than taxes paid today o Example: If you pay on December 29, 2015, the deductible will be for 2015 and you will get your tax refund on April 15, 2016. However, if you pay on January 5, 2016, the deductible will be for 2016 and you will get your tax refund on April 15, 2017. § By paying just 7 days earlier, your tax refund will be received an entire year earlier. • Example: Sarah, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In mid-December she received an $18,000 bill from her accountant for consulting services related to her small business. Sarah can pay the $18,000 bill anytime before January 30 of the next year without penalties. Assume her marginal tax rate is 35% this year and next year, and that she can earn an after-tax rate of return of 10% higher on her investments. When should she pay the $18,000 bill, this year or next? o Sarah should pay the bill NOW § Paying this year: $11,700 after-tax cost of consulting services § Paying next year: $12,273.30 after-tax cost of consulting services Timing Strategies When Tax Rates Change • Taxpayer must calculate the optimal tax strategies for deductions & income when tax rates are increasing o Must calculate to determine whether the benefit of accelerating the deductions outweighs the disadvantage of recognizing the deductions in a lower tax rate year o Must also calculate in order to determine if the benefit of deferring income outweighs the disadvantage of recognizing the income in a higher tax rate year • The higher the tax rate, the higher the tax savings for a deduction • The lower the tax rate, the lower the tax costs for taxable income o Taxpayers should prefer to recognize income during low tax rate years & deductions during high tax rate years • Causes for tax rates to change: o Taxable income changes because of: § Changes in job § Retiring § Starting a new business § Having children § Getting married § Tax legislation • Taxpayers should accelerate tax deductions into earlier years & defer taxable income to later years when tax rates are decreasing o Accelerating deductionà maximizes PV of tax savings from deductions due to the acceleration of the deductions into earlier years with a higher tax rate year § Takes advantage of tax savings o Deferring incomeà minimizes PV of taxes paid due to the deferral of the income to later years with a lower tax rate • Always try to accelerate deductions & put off income • Example: Sarah has decided that she needs new equipment for her business, so she is considering whether to make the purchase and take the $11,000 deduction at the end of this year or the next year. Sarah anticipates that, with the new equipment, her business income will increase, causing her marginal rate to increase from 20% to 30% next year. Assuming her after-tax rate of return is 10%, what should Sarah do? o Tax rates are increasingà buy next year § This year: $8,800 after-tax cost of equipment § Next year: $8,000.30 • Tax savings are greater Limitations of Timing Strategies • Without the actual cash flow that generates deduction, tax deduction can’t be accelerated o Sometimes don’t have control over timing of cash outflows • Taxpayers required to continue their investment in asset to defer income recognition for tax purposes o Deferral NOT an option if taxpayer has “cashed out” of investment • If taxpayer has cash flow needs, deferral strategy may not be optimal o Taxpayer may need the cash o Or if continuing investment produces a low return (compared to other potential investment options) or puts taxpayer at an unnecessary risk o Constructive receipt doctrine—taxpayer required to recognize income when it’s actually/constructively received § If all my rights are there & I’m aware it’s available to me, I can’t pull it off § Occurs if: • Income is unconditionally available to taxpayer • Taxpayer is aware of income’s availability • No restrictions on taxpayer’s control over the income • Example: Bob recently won a lottery and chose to receive $75,000 today instead of an equivalent in 10 years, computed using an 8% rate of return. Today, he learned that interest rates are expected to increase in the future. Is this good news for Bob given his decision? o FV of 75,000 10 years at 8% interest = 75,000 X 2.15892 = $161,919 o PV of 161,919 10 years if interest is 10% = 161,919 X .386 = $62,500.73 o Bob would therefore prefer to have the $75,000 TODAY. This is good news • Example: Assume Sarah can earn a 10% after-tax rate of return. Would she prefer the $2,000 today or $3,500 in 5 years from now? o PV of $3,500 in 5 years at 10% = $3,500 X .621 = $2,173.50 o PV of $2,000 today = $2,000 o Receiving $3,500 in 5 years is better Income Shifting Strategies • Shift income from high-tax rate taxpayers/jurisdictions à low-tax rate taxpayers/jurisdictions OR shift deductions from low-tax rate à high-tax rate o Different states & countries may have different tax rates • Transactions between family members o Children have lower marginal tax rates § Parents may shift income to children so it will be taxed at the child’s tax rate o Limitations: § Assignment of income doctrine—income must be taxed to the taxpayer who actually earns it § Watch out for related-party transactions to be scrutinized to be unreasonable in amount • Transactions between owners & their businesses o Lower current taxation of business income can result from shifting income from individual to corporation (incorporating a business) o Shifting income from corporation to owner through tax deductible expenses (ex: rent, compensation, interest) § Allows owners to avoid double taxation on corporate profits • Taxpayers who benefit most from income shifting are: o Related parties—family members or businesses & owners—who have varying tax rates & are willing to shift income for group’s benefit o Taxpayer operating in multiple jurisdictions w/ different marginal tax rates • Form of business also important o Sole proprietorships are NOT separate from the business owner; corporations are separate • Advantage of C-Corp filing a separate tax return vs. sole proprietorship on same return as taxpayer • Be careful of amounts set for compensation, rent, & any other transaction between corporation & owner to make sure they are reasonable in amount or the IRS will reclassify them as dividends & then they will be nondeductible to corporation & taxable to owner à double-taxation • Transactions across jurisdictions o Income earned in different jurisdictions are tax differently § Differences used by taxpayers to maximize their after-tax wealth § Ex: football players playing a game in Charlotte must compute taxes for North Carolina for income earned in that game § May be non-tax consequences of moving to lower-tax jurisdictions • Poorer quality workers, negative publicity from moving jobs from US, fewer services available, etc. o IRS examination of implicit taxes, kiddie tax, related party transactions, negative publicity, & judicial doctrines (income assignment) limit income shifting strategies § Occurs when companies operate in multiple countries • Could get lower tax rates in other countries & get bad press for it Conversion Strategies • Tax rates vary across different activities o Ordinary income taxed at ordinary rates § Want to converge ordinary to long-term or exempt § Ordinary income: salary, interest income, business income o Long-term capital gains taxes at preferential ratesà maximum of 20% o Some income is even tax exempt § Non-taxable compensation benefits § Municipal bond interest • Tax rates can vary from year to year, from taxpayer to taxpayer, from jurisdiction to jurisdiction, & from activity to activity • Other types of income taxed at lower tax rates (currently maximum= 20%) o Long-term capital gains—gains from sale of investment assets held longer than 1 year o Certain dividends • Conversion strategy based on understanding that tax law does not treat all types of income/deductions the same • Implementing strategy required: o Understand differences in tax treatment for all types of income, expenses, & activities o Have ability to alter nature of income/expense to receive the more advantageous tax treatment § Have control over investments & timing • After-Tax Return = Before-Tax Return – (Before-Tax Return X Marginal Tax Rate) • Example: Bob is deciding between 3 different investments, each with the same amount of risk: o A) A high-dividend stock that pays 9% dividends annually with no appreciation potential o B) Taxable corporate bonds that pay 9.5% interest annual o C) Tax-exempt municipal bonds that pay 6.5% interest annually o Assume that dividends are taxed at 25% and that Bob’s marginal tax rate on ordinary income is 35%, which investment should he choose? § A) High-dividend stock = 0.09 X (1-0.25) = 6.75% § B) Corporate bond = 0.095 X (1-0.35) = 6.18% § C) Municipal bond = 0.065 X (1-0) = 6.5% § The high-dividend stock would give the highest return for the investment • Possible to combine the benefits of timing strategy & conversion strategy if you hold assets for longer than 1 year o Taxpayer can defer recognizing gain on assets until they sell them o Taxpayer can pay taxes on gains at a preferential rate § Hold assets for a longer period of time, pays lower tax rate on capital gain Limitations of Conversion Strategies • Code includes requirements that prevent taxpayers from changing the nature of expenses & income • Implicit taxes may reduce/eliminate advantages • Judicial doctrines (business purpose, step transactions, substance-over-form, & economic substance) may limit use of strategy o If it smells like it’s a tax avoidance transaction, the IRS will shut it down Judicial Doctrines • Constructive Receipt • Assignment of Income o Requires income to the taxed to taxpayer who actually earns the income § Assigning a paycheck or dividend to another taxpayer does NOT transfer tax liability o Fruit & the tree metaphor § Fruit doesn’t fall far from the tree • Related-Party Transactions o IRS examines because they are usually not arms-length transactions § 2 non-related buyers enter into transaction • Business Purpose Doctrine o IRS has power to disallow business expenses for transactions without a business purpose o Ex: paying for own electric bill at my houseà NOT a business transaction • Step-Transaction Doctrine o IRS has power to collapse series of transactions into one in order to determine tax liability • Substance-Over-Form Doctrine o IRS can reclassify transaction according to its substance (instead of its form—what it looks like) § See what it’s really trying to doà not what it looks like it’s trying to do • Economic Substance Doctrine o Must meet 2 criteria: § 1. Meaningfully change a taxpayer’s economic position (excluding any federal income tax effects) § 2. Substantial purpose (other than tax avoidance) for transaction Tax Avoidance vs. Tax Evasion • Tax Avoidance—legal & endorsed by courts & Congress o Legal (under revenue code) act of arranging transactions in order to minimize taxes paid • Tax Evasion—willful attempt to defraud government o Illegal o Outside confines of legal tax avoidance o May put taxpayer in prison
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