Chapter
4
Basic Maxims of Income
Tax Planning
Tax Avoidance and Basic Tax Planning
Avoidance is legal
Tax evasion is a federal crime
This course teaches tax planning (avoidance), not
evasion –
General Rule: Defer tax payments for as long as
possible within the realm of the law
Income Tax Planning - Entity
Generally, taxable income is basically computed
the same for different entities.
However, the amount of tax paid depends on the
difference in tax rates across entities. The two
primary tax paying entities are corporations and
individuals.
Income Tax Planning - Entity
Individual taxpayers
have a progressive tax rate structure that
ranges from 10% to 35% (as of May 2003)
see the inside front cover of text. Corporate
taxpayers
have a progressive tax rate structure that
ranges from 15% to 35% for richest
corporations.
see the corporate tax rates in text. Marginal
rates of 38% and 39% eliminate benefits of
lower brackets.
Income Tax Planning - Entity
Income Shifting
Arrange transactions to transfer income from a high
tax rate entity to a low tax rate entity or from a high
rate tax year to a low tax rate year.
Deduction Shifting
Arrange transactions to transfer deductions from a
low tax rate entity to a high tax rate entity or from a
low rate tax year to a high rate tax year.
Assignment of Income Doctrine prohibits
shifting of income from property UNLESS the
property is transferred also.
Income shifting during periods of changing
rates may compete with general tax deferral
maxim.
Income Tax Planning - Time
Because income is reported only once a
year, the tax paid or tax savings from any
transaction depends on the year the
transaction occurs.
In present value terms, tax costs
decrease (and cash flows increase)
when a tax liability is deferred until a later
taxable year. Limited by:
Opportunity Costs
Tax Rate Changes
Income Tax Planning - Time
Opportunity Costs
Shifting tax liabilities to a later period also may
entail shifting income to a later period. Thus,
the opportunity costs of shifting the income may
be greater than the tax savings associated with
the liability deferral.
Tax Rate Changes
If taxpayers defer a tax liability to a future date
and Congress increases tax rates the benefits
of the deferral may be lost or substantially
limited.
Income Tax Planning - Character
Ordinary income: generated by the routine operations of a
business or investment activity and is subject to tax at
regular tax rates. This includes service income, sales,
interest, royalties, and rents.
Capital income generated by the sale of capital assets (see
chapter 8) and has consistently been subject to lower tax
rates than ordinary income. (e.g. 15% for individuals) (Now
some dividends too)
Some income is nontaxable. E.g.: Municipal bond income,
many fringe benefits.
Taxpayers look to convert ordinary income into capital
where possible for rate benefit.
Tax Law Doctrines Business Purpose Doctrine - must have a business
purpose other than tax avoidance.
Substance Over Form Doctrine - IRS can look
through legal formalities to determine economic
substance.
Ability to Pay Doctrine: Generally requires a
realization transaction to have item subject to tax
Return of Capital Doctrine: Return of original
investment made with after tax dollars not subject to
tax.