Variables that Create Tax
Planning Opportunities
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4-1
Entity variable
Time period variable
Jurisdiction variable
Character variable
Caveat: We will discuss manipulation of
these variables while first assuming
equivalent before-tax cash flows and no
differential non-tax costs
Important Differences in
Taxation of Business Entities
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Which of the following are ‘taxable entities’
and which are ‘conduit entities’?
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4-2
Individuals
C Corporations
S Corporations
Partnerships
Limited Liability Companies
Trusts and Estates
Important Differences
continued
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C corporations
• Income subject to double taxation
• Income taxed to entity when earned
• A dividend distribution of after-tax earnings is taxed
again to shareholders when paid
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Conduit entities
• Income not taxed at the entity level
4-3
• Taxed to owners when earned by the entity, regardless
of whether any of such earnings are distributed
• Distributions of earnings to owners are not taxed
Entity Variable continued
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Maxim: Tax costs decrease (and cash flows
increase) when income is generated by an
entity subject to a low tax rate
Constraints on income/deduction shifting
strategies:
• Usually have to shift before-tax cash flow in
order to shift tax cost
• Assignment of income doctrine
4-4
In-Class Problem: Tax Planning
and the Entity Variable
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4-5
Joe is planning to invest $100,000 in a small
business venture expected to generate a 10%
before-tax return on investment. Given his
other sources of income, Joe’s marginal tax
rate is 38.6%.
Joe is considering incorporating his new
business to take advantage of the lower
marginal tax rate available to the new
corporation.
In-Class Problem continued
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Under each alternative:
• Compute Joe’s after-tax cash flow in the first year.
• If Joe reinvests the after-tax earnings of the business each
year, and the investment continues to earn a 10% before-tax
return, compute the accumulated value after 5 years.
• If Joe liquidates the business in 5 years, compute his total
after-tax earnings, assuming that:
• If the investment is made personally, no additional tax is due on
liquidation
• If the investment is made through the corporation, Joe is taxed on the
liquidated value in excess of his original investment
4-6
Time Period Variable
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4-7
Maxim: In present value terms, tax costs
decrease (cash flows increase) when tax
liability is deferred until a later taxable year
Optimal use of this strategy may require that
tax liability be deferred without deferring
pre-tax cash flows, unless other factors vary
across time periods
In-Class Problem
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4-8
Mallory is a self-employed consultant and
uses the cash basis of accounting for tax
purposes. Mallory is negotiating with a new
client on the timing of payment for a lengthy
project estimated to cost $50,000. She is
considering requesting payment of 1/2 of her
fee now and 1/2 in one year when the project
is complete, versus receiving the entire fee
next year.
In-Class Problem continued
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4-9
Using a 10% discount rate, compute Mallory’s aftertax cash flow from each alternative assuming a
38.6% marginal tax rate for both years.
If Mallory qualified to use the completed-contract
method of accounting (so that all income from the
project would be taxed when completed) how would
your answers to question 1 change?
How would your answers to question 1 change if
Mallory’s marginal tax rate is only 27% next year?
Jurisdiction Variable
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Maxim: Tax costs decrease (cash flows
increase) when income is generated in a
jurisdiction with a low tax rate
• Examples: differential tax rates across state and
local taxing jurisdictions, differential tax rates
from foreign versus U.S. business operations
4-10
Character Variable
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Maxim: Tax costs decrease (cash flows
increase) when income is taxed at a
preferential rate because of its character
Examples:
• Gains realized by individuals on the sale of
investment assets (capital gains) are taxed at a
maximum 15% tax rate
• Interest earned on municipal bonds is taxed at a
preferential tax rate of zero
4-11
In-class Problem: Capital Gains
Taxation
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Candace sold an investment asset for $100,000, producing
a capital gain of $20,000. Calculate Candace’s after-tax
cash flow from the sale under each of the following
scenarios:
• Candace’s marginal tax rate on ordinary income is 38.6% and the
gain is long-term
• Candace’s marginal tax rate on ordinary income is 38.6% and the
gain is short-term
• Candace’s marginal tax rate on ordinary income is 15%
• Candace is a corporation (Candace Inc.) with a marginal tax rate
of 34%
4-12
Important Tax Doctrines
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4-13
Business purpose - other than tax avoidance
Substance over form - taxability of transaction
determined by economic reality rather than
(perhaps contrived) appearance
Step-transaction - allows the IRS to collapse a
series of interdependent transactions into a single
transaction to determine the ultimate tax result
Example: Business Purpose
Doctrine
In the landmark case of Gregory vs. Helvering, the taxpayer
created, reorganized and liquidated a corporation all within 6 days
for the sole purpose of changing ordinary income (dividend) into
capital gain. The subsequent dispute with the IRS was ultimately
heard by the Supreme Court, who held that the formation and
liquidation of the corporation “was in fact an elaborate and
devious form of conveyance masquerading as a corporation
reorganization” with no business purpose other than saving taxes.
In disregarding the transaction, the court stated that “to hold
otherwise would be to exalt artifice above reality and to deprive
the statutory provision in question of all serious purpose.”
4-14
Example: Substance over
Form
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Bill is the owner of Bill’s Sub Shop. In order
to lower his taxable income from the shop,
Bill ‘employs’ his 3-year-old daughter as a
janitor at a salary of $200 per week.
• Does Bill’s employment of his daughter reflect
economic reality?
• Should Bill be allowed to deduct the salary paid
to his daughter?
• What if Bill’s daughter were 15 and worked 20
hours per week in the sub shop?
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