Chapter 3
Tax Planning Strategies and
Related Limitations
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Learning Objectives
1.
2.
3.
4.
Identify the objectives of basic tax planning
strategies.
Apply the timing strategy and describe its
applications and limitations.
Apply the concept of present value to tax
planning.
Apply the strategy of income shifting,
provide examples, and describe its
limitations.
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Learning Objectives (Cont.)
5.
6.
7.
Apply the conversion strategy, provide
examples, and describe its limitations.
Describe basic judicial doctrines that
limit tax planning strategies.
Contrast tax avoidance and tax
evasion
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Basic Tax Planning Overview
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Effective planning requires consideration for
both tax and non-tax factors
In general terms, effective tax planning
maximizes the taxpayer’s after-tax wealth
while achieving the taxpayer’s non-tax goals
3 parties to every transaction: taxpayer,
other party, and the government
3 basic planning strategies: timing, income
shifting, and conversion
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Timing Strategies

When income is taxed or an expense is
deducted affects the associated “real” tax
costs or savings for 2 reasons
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(1) the time that income is taxed or an expense is
deducted affects the present value of the taxes
paid on income or the tax savings on deductions.
(2) the tax costs of income and tax savings
income vary as tax rates change
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Timing Strategies

The concept of Present Value.
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$1 today is worth more than $1 in the future.
The implication of the time value of money for tax
planning is that the timing of a cash inflow or a cash
outflow affects the present value of the income or
expense
When considering cash inflows, higher present
values are preferred; when considering cash
outflows, lower present values are preferred
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Timing Strategies
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
Present Value = Future Value / (1 + r)n
Exhibit 3-1 provides the discount rates for a
lump sum (single payment) received in n
periods using various rates of return
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Timing Strategies

Two basic tax-related timing strategies:

Accelerating deductions

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Essentially accelerating a current cash inflow
Deferring income

Essentially deferring a current cash outflow
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Timing Strategies When Tax
Rates Change
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
When tax rates are increasing, the taxpayer
must calculate the optimal tax strategies for
deductions and income. Why?
When tax rates are decreasing, taxpayers
should accelerate tax deductions into earlier
years and defer taxable income to later years.
Why?
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Limitations of Timing
Strategies
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The tax deduction often cannot be accelerated without
the actual cash outflow that generates the deduction
Tax law generally requires taxpayers to continue their
investment to defer income
Deferral strategy may not be optimal if taxpayer has
cash flow needs, or if continuing investment generates
low returns or subjects taxpayer to unnecessary risk
Constructive receipt doctrine: taxpayer must
recognize income when it is actually or constructively
received
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Income Shifting Strategies

Income shifting exploits the differences in tax rates
across taxpayers by shifting income from high-tax rate
taxpayers (jurisdictions) to low-tax rate taxpayers
(jurisdictions) or shifting deductions from low-tax rate
taxpayers (jurisdictions) to high-tax rate taxpayers
(jurisdictions)

Transactions between family members
Transactions between owners and their businesses
Transactions across jurisdictions
Several factors limit this strategy
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Conversion Strategies
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The conversion strategy is based on the
understanding that the tax law does not treat all
types of income or deductions the same
To implement the conversion strategy, you must:
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Understand the 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
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Limitations of Conversion
Strategies
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The Code itself also contains provisions to
prevent a taxpayer from changing the nature
of expenses and income
Implicit taxes
Judicial doctrines
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Additional Limitations to Tax Planning
Strategies: Judicial Doctrines
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Constructive Receipt
Assignment of income
Related-party transactions
Business purpose doctrine
Step-transaction doctrine
Substance-over-form doctrine
Economic substance doctrine
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Tax Avoidance vs. Tax
Evasion
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The previous strategies fall into legal tax
avoidance.
Tax evasion: the willful attempt to defraud
the government
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