Lecture Notes
Chapter 3: Tax planning strategies & related limitations
ACCT 5400 – Fall 2018 – Demeré
1. Basic Tax Planning (page 3-2)
➢ What is the general goal of effective tax planning?
• Maximizing a taxpayer’s __________________ wealth while achieving a taxpayer’s
_______________ goals.
• Effective tax planning does not necessarily mean minimizing taxes
❖ What is the best way to minimize taxes? _____________________________.
➢ Effective tax planning requires consideration of:
• All _______________________ (income tax, sales tax, gift tax, etc.)
• All _______________________ (the taxpayer, the other transacting party, the
government/taxing authorities)
❖ Examples: Buyer vs. Seller; Employer vs. Employee; Donor vs. Donee
• All _______________________ (tax costs and non-tax costs (e.g., cash needs, labor
costs, audit costs, etc.))
➢ What are the three types of tax planning strategies considered in this chapter?
• Timing strategies
• Income shifting strategies
• Conversion strategies
2. Timing Strategies (pages 3-2 through 3-11)
➢ The Basics
• Timing strategies are based on the fact that ____________________ income is taxed
or an expense is deducted affects the associated “___________” tax costs or savings.
• Why does the timing of income/expense recognition affect real costs?
❖ Timing affects the _____________________________ of taxes paid/tax savings.
❖ The tax costs of income and tax savings of deductions vary as
_____________________________ across years.
➢ Time value of money
• This concept states that $1 _____________ > $1 _______________. Why is this true?
❖ Because $1 today can be invested at the expected after-tax rate of return
yielding greater than $1 tomorrow.
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• The following formula computes the future value of a current cash flow:
❖ Future Value = _________________________________, where r is the after-tax
rate of return and n is the investment period
▪
Example: Assuming an expected after-tax rate return of 8%, what will $1
invested today be worth in one year?
→ Future Value = $1 x (1 + 0.08)1 = ________________
• Tax planners often consider the time value of money in terms of
_______________________________ (i.e., what does a future tax (deduction) cost
(save) us in current dollars?)
• The following formula computes the present value of a future cash flow:
❖ Present Value = _________________________________, where r is the after-tax
rate of return and n is the investment period
▪
Example: Assuming an expected after-tax return of 8%, what is the
present value of $1 of tax savings received in one year?
→ Present value = $1/(1 + 0.08)1 = ________________
• General rules of thumb
❖ When considering cash _______________ (tax savings), prefer ____________
present values
❖ When considering cash _______________ (taxes paid), prefer ____________
present values
➢ General timing strategies when tax rates are constant
• Because of the time value of money, it is advantageous to:
❖ ___________________ tax deductions (to an earlier period)
❖ ___________________ recognizing taxable income (recognize in a later period)
✓ Let’s practice! Example 1: Daenerys has the option of earning and receiving $2,000
today, December 31st, or tomorrow, January 1st. Assume Daenerys’ tax rate is 35% in
both years and the prevailing interest rate is 10%. How much will Daenerys save by
deferring the $2,000 of income?
➢ General tax strategies when tax rates are changing
• Recognize _________________________ during low-tax-rate years
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❖ Why → Income is taxed less in years with lower tax rates
• Recognize _________________________ during high-tax-rate years
❖ Why → Deductions are worth more in years with higher tax rates
• When might you anticipate a change in a taxpayer’s marginal tax rate?
❖ Job change (PhD student to Professor; student to full-time employee);
retirement; getting married (or divorced); Legislative changes in tax rates
➢ Table summarizing general timing strategies:
Type of Item
Income
Deduction
Increasing
Marginal Tax Rate
Decreasing
Unchanged
Does benefit of lower rate in the current year offset earlier recognition of income (i.e.,
time value of $)?
2 Does benefit of earlier deduction (i.e., time value of $) offset lower rate applied to
deduction in the current year?
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✓ Let’s practice! Example 2: Basic Timing Example – Income. Viserys has the option of
earning $1,000 on December 31st of Year 1 or January 1st of Year 2. Assuming that the
interest rate is 8%, what should he do in the following scenarios?
Scenario 1
Scenario 2
Year 1 Tax Rate
24%
32%
Year 2 Tax Rate
32%
24%
✓ Let’s practice! Example 3: Basic Timing Example – Deductions. Drogo has the option
to take a $2,000 deduction on December 31st of Year 1 or January 1st of Year 2.
Assuming that the interest rate is 8%, what should Drogo do in the following
scenarios?
Scenario 1
Scenario 2
Year 1 Tax Rate
28%
33%
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Year 2 Tax Rate
33%
28%
➢ What are the limitations to timing strategies?
• Limitation 1: The timing strategy is less beneficial if a taxpayer cannot accelerate a
deduction without accelerating the actual ________________________.
• Limitation 2: The taxpayer must ________________________________ in an asset to
defer income recognition for tax purposes.
❖ This will constrain a taxpayer if:
▪ The taxpayer has severe _________________________ needs;
▪ Continuing to hold the investment would generate a low rate of return
relative to other investments; and/or
▪ The investment would subject the taxpayer to unnecessary ___________.
• Limitation 3: The __________________________________ doctrine
❖ Applies to cash-method taxpayers (we will revisit in Chapter 9)
❖ Income is deemed realized if:
▪ It is ________________________ available (even without physical
possession);
▪ The taxpayer is __________________ of the income’s availability; and
▪ There are no restrictions or limits over taxpayer’s control of the income
✓ Let’s practice! Example 4: Constructive Receipt Doctrine. Targaryen Ltd. issues its
usual annual bonus on December 30th of Year 1 but Rhaegar left on a cruise to King’s
Landing on December 20th of Year 1. Upon his return on January 14th, Year 2,
Rhaegar picks up the check from his mailbox at work and deposits it. When is it
included in income?
3. Income-Shifting Strategies (pages 3-11 through 3-15)
➢ Income shifting strategies are based on the fact that tax rates vary across:
• Taxpayers
• Jurisdictions (states, countries, etc.)
➢ What are the general incoming shifting strategies?
• Shift _____________ to taxpayers (or jurisdictions) with _____________ tax rates
❖ Why → Income is taxed less for taxpayers with lower tax rates
• Shift _____________ to taxpayers (or jurisdictions) with _____________ tax rates
❖ Why → Deductions are worth more to taxpayers with higher tax rates
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➢ Transactions between family members
• Children generally have _______________ marginal tax rates → parents may shift
income to children so it will be taxed at the child’s tax rate.
• Limitations:
❖ _________________________________ doctrine: Requires income to be taxed
to the taxpayer who actually earns it
▪
▪
Wages are taxed to the taxpayer earning the income;
Dividends and other investment income is taxed to the taxpayer that
owns the asset (additional limitations such as kiddie tax apply when
shifting investment income…we will see this in Chapter 8)
❖ IRS scrutiny of ______________________________ transactions
➢ Transactions between owners and their businesses
• _______________________ a business and thus shifting income from an individual
to the corporation may result in lower current taxation of the business income
• Shifting income from a corporation to an owner through tax deductible expenses
(e.g., compensation, interest, rent) allows the owners to avoid
_______________________________ on corporate profits
• Limitation: IRS scrutiny of related-party transactions
➢ Transactions across jurisdictions
• Income earned in different jurisdictions is often taxed very ____________________.
• Taxpayers can use these differences to maximize their after-tax wealth.
❖ Limitations: IRS scrutiny of transfer pricing, implicit taxes (non-tax costs of
operating in a low-tax jurisdiction), and negative publicity (e.g., for moving
operations abroad)
✓ Let’s practice! Example 5: Income Shifting. Arryn owns a sword service that cleans and
sharpens swords nightly. Arryn, a high-tax rate taxpayer, would like to shift some
income to his son Vale. Arryn tells all of his customers (who are always timely in their
payments) to pay Vale and then Vale will report 50% of the income as a collection fee.
Arryn will report the remaining 50%. Will this shift the income from Arryn to Vale?
Why or why not?
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✓ Let’s practice! Example 6: Income Shifting. Lysa owns and operates a sole
proprietorship and has a 35% marginal tax rate. She provides her son, Robin, $10,000 a
year for college expenses. Robin works as a pizza delivery person every fall and has a
marginal tax rate of 15%.
• What could Lysa do to reduce her family tax burden?
• How much pretax income does it currently take Lysa to generate the $10,000 aftertaxes given to Robin?
• If Robin worked for his mother’s sole proprietorship, what salary would she have
to pay him to generate $10,000 after taxes (ignoring any Social Security, Medicare,
or self-employment tax issues)?
• How much money would this strategy save?
4. Conversion Strategies (pages 3-15 through 3-18)
➢ Conversion strategies are based on the fact that tax rates vary across different
____________________.
• Given certain activities/investments are “____________________,” the taxpayer can
attempt to change the form of income (or expense) to a form that is tax-advantaged
➢ How do taxpayers analyze the benefits of conversion strategies?
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• Taxpayers often compare the after-tax returns of alternative investments to analyze
the benefits of conversion strategies.
• ___________________________ (ATR) = Pre-tax Return – (Pre-tax Return x MTR)
= Pre-tax Return x (1 – MTR)
➢ What are some examples of conversion?
• Converting cash compensation into nontaxable or tax-deferred forms of
compensation (e.g., employer-provided health insurance, retirement contributions,
stock options)
• Converting ____________________ expenses into ____________________ expenses
• Converting hobby or personal expenses into investment or business expenses
• Convert capital losses into ordinary losses (recognize 3,000 of excess capital losses
relative to capital gains)
• Invest in assets that produce tax-exempt rather than taxable income
• Giving child money for college vs. employing them and paying them wages
✓ Let’s practice! Example 7: Conversion. Petyr is considering the following
investments:
1. A stock that pays 6% dividends annually but has no appreciation potential (i.e.,
no capital gains).
2. A Coca-Cola (taxable) bond that pays 10% interest annually.
3. A City of Athens (tax-exempt) bond that pays 7% interest annually.
Assuming dividends are taxed at 15% and that Petyr’s MTR on ordinary income is
35%, which investment should Petyr choose?
➢ What are some of the limitations to conversion strategies?
• Specific tax rules such as some of the depreciation recapture rules
• Implicit taxes
5. Additional limitations to tax planning strategies (pages 3-18 through 3-19)
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➢ Business purpose doctrine:
• To be deductible, the expense of a business must be incurred for the
____________________ of generating ____________________ income
• E.g., construction company cannot build a swimming pool at the owner’s home
and deduct all the costs of such construction; can’t take a spouse on a business trip
and expense it
➢ Step-transaction doctrine:
• If a series of transactions are undertaken, the IRS can _________________ the
transactions into a _________________ transaction and look at the end result to
determine what the tax treatment should be.
• E.g., Parent lends money to the child and charges no interest. The child lends the
money to a corporation owned by the parent and charges 10% interest. IRS will
look at the overall transaction and not allow the interest as income to the child, but
to the parent.
➢ Substance-over-form doctrine
• Tax generally follows the legal form of a transaction—debt is debt, salary is salary,
etc.
• HOWEVER, IRS looks at the ________________________of the transaction to
ensure it is consistent with the form chosen. If the substance is inconsistent with
the form, the IRS can reclassify the transaction according to its substance.
• Examples:
❖ A parent pays dependent child $10,000 salary to answer phones for the
family business one afternoon per month. IRS would likely reclassify most of
the $10,000 as a gift from the parent to the child
❖ An owner/manager takes $75,000 as salary every year, no matter what the
income before owner’s salary is. Some portion of this, particularly in highincome years, is likely a dividend and not salary
➢ Economic substance doctrine
• Transactions must:
❖ Meaningfully change a taxpayer’s economic position (excluding any federal
income tax effects)
❖ Have a ___________________________ purpose (other than tax avoidance)
• 40% underpayment penalty if tax position does not meet requirements
6. Tax avoidance versus tax evasion (pages 3-19 through 3-20)
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➢ Tax avoidance: Legal
________________ act of arranging one’s transactions to minimize taxes
paid
Willful
➢ Tax evasion: ________________
attempt to defraud the government by not paying taxes
legally owed
➢ Line between tax avoidance and tax evasion is not always clear
Going forward: An understanding of these simple tax planning strategies combined with
knowledge of our tax law (our focus for the rest of the semester) will enable you to identify and
implement legal tax planning strategies.
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