Principles of Taxation Chapter Basic Maxims of Income Tax Planning Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives Slide 4-2 Tax avoidance versus tax evasion Tax planning variables The Entity The Time Period The Jurisdiction The Character of Income Explicit and implicit taxes Tax law doctrines Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Avoidance Slide 4-3 Avoidance is legal Tax evasion is a federal crime This course teaches tax planning (avoidance), not evasion - your questions like: ‘The IRS can’t find this type of income, can they?’ are interesting from a compliance standpoint, but will permit a discussion of ethics and evasion as well Just as we hope (and trust? - or monitor?) that you not cheat in class, we expect that you will not evade taxes as future businessmen and women Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Entity Slide 4-4 Generally, taxable income is 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 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Entity Slide 4-5 Individual taxpayers have a progressive tax rate structure that ranges from 15 percent to 39.6 percent see the inside front cover of text Work AP2 Corporate taxpayers have a progressive tax rate structure that ranges from 15 percent to 35 percent for richest corporations see the corporate tax rates in text Marginal rates of 38% and 39% eliminate benefits of lower brackets Work AP1 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Entity Slide 4-6 Tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate When establish a new business, consider the tax rates paid by the form of business entity See chapter 11 flow-through versus corporation What about established business entities? Reducing tax liabilities may depend on: Income Shifting Deduction Shifting Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Entity Slide 4-7 Irwin/McGraw-Hill Income Shifting Arranging transactions for the purpose of transferring income from a high tax rate entity to a low tax rate entity Work AP5 Deduction Shifting Arranging transactions for the purpose of transferring deductions from a low tax rate entity to a high tax rate entity Work AP4 Assignment of Income Doctrine prohibits shifting of income from property UNLESS the property is transferred also See AP3 ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Time Slide 4-8 Because federal and state taxing authorities impose a tax on income 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 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Time Slide 4-9 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 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Time & Opportunity Costs Slide 4-10 Assume that a taxpayer has a tax rate of 30 percent and a 10% discount rate Compare the following: a) Taxpayer can receive $100 income and pay tax now After-tax value = $70 OK b) Taxpayer can delay $100 income and tax both by one year PV of after-tax value of $70 x 0.909 = $64 WORSE c) Taxpayer can delay $100 income by one month but delay tax effect by one year PV of pre-tax value = $100 x 0.99 = 99 PV of tax cost = ($30) x 909 = (27) Net $92 BEST Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning - Time and Tax Rate Changes Slide 4-11 Suppose in c), Congress changes the tax law to increase the tax rate to 35% Then, the PV of pre-tax income is still $99 However, PV of tax cost is ($35) x 909 = ($32) Net = $67 WORSE See also AP8, Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Jurisdiction Slide 4-12 The Jurisdiction variable has become increasingly important because: state laws differ and country laws differ Much more opportunity for related-party tax planning Tax Costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Jurisdiction Slide 4-13 Multinational example: U.S Parent company faces a 35% tax rate Subsidiary in Japan faces a 50% tax rate U.S manufactures a product for $100 and Japanese subsidiary packages it and markets it for $200 Packaging and marketing costs are $10 What price would the the parent prefer to charge the sub? (Note - most countries have laws requiring ‘arms’ length’ prices.) For discussion: IR2 See also Chapter 12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Income Character Slide 4-14 Ordinary income is generated by the routine operations of a business or investment activity This includes service income, sales, interest, dividends, royalties, and rents Ordinary income is subject to tax at regular tax rates Capital income is generated by the sale of capital assets (see chapter definition) Capital income has consistently been subject to lower tax rates than ordinary income (e.g 20% for individuals) Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Income Character Slide 4-15 Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character Because one form of income receives preferential tax rates, taxpayers are continually trying to arrange transactions to convert ordinary income into capital income The Tax Code contains dozens of provisions that prohibit the artificial conversion of ordinary to capital income Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Slide 4-16 Summary Entity, Time, Jurisdiction, Character Sometimes these planning maxims conflict E.g., defer tax to a later period but at a higher tax rate - must compute NPV to evaluate Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Implicit Taxes Slide 4-17 The reduction in rate of return that a taxpayer receives because the market has bid up the price of a tax-favored asset Easiest example is municipal bonds: If taxable bonds are yielding 10%, and if the top tax bracket is 40%, then municipal bonds will yield about 6%, because rich taxpayers will buy municipals as long as the interest rate is at least 6% If not enough rich taxpayers demand municipal bonds, the rates may be slightly higher See AP10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Law Doctrines IRS calls foul Slide 4-18 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 Step Transaction Doctrine - IRS can collapse a series of transactions into one Rule of thumb transactions more than a year are presumed to be independent Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 [...].. .Income Tax Planning - Time and Tax Rate Changes Slide 4- 11 Suppose in c), Congress changes the tax law to increase the tax rate to 35% Then, the PV of pre -tax income is still $99 However, PV of tax cost is ($35) x 909 = ($32) Net = $67 WORSE See also AP8, 9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Jurisdiction Slide 4- 12 The Jurisdiction... See also Chapter 12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Income Character Slide 4- 14 Ordinary income is generated by the routine operations of a business or investment activity This includes service income, sales, interest, dividends, royalties, and rents Ordinary income is subject to tax at regular tax rates Capital income is generated by the sale of capital... assets (see chapter 7 definition) Capital income has consistently been subject to lower tax rates than ordinary income (e.g 20% for individuals) Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Income Character Slide 4- 15 Tax costs decrease (and cash flows increase) when income is taxed at a preferential rate because of its character Because one form of income receives... preferential tax rates, taxpayers are continually trying to arrange transactions to convert ordinary income into capital income The Tax Code contains dozens of provisions that prohibit the artificial conversion of ordinary to capital income Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Slide 4- 16 Summary Entity, Time, Jurisdiction, Character Sometimes these planning maxims. .. Much more opportunity for related-party tax planning Tax Costs decrease (and cash flows increase) when income is generated in a jurisdiction with a low tax rate Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Income Tax Planning Jurisdiction Slide 4- 13 Multinational example: U.S Parent company faces a 35% tax rate Subsidiary in Japan faces a 50% tax rate U.S manufactures a product for... E.g., defer tax to a later period but at a higher tax rate - must compute NPV to evaluate Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Implicit Taxes Slide 4- 17 The reduction in rate of return that a taxpayer receives because the market has bid up the price of a tax- favored asset Easiest example is municipal bonds: If taxable bonds are yielding 10%, and if the top tax bracket is 40 %, then... yield about 6%, because rich taxpayers will buy municipals as long as the interest rate is at least 6% If not enough rich taxpayers demand municipal bonds, the rates may be slightly higher See AP10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Law Doctrines IRS calls foul Slide 4- 18 Business Purpose Doctrine - must have a business purpose other than tax avoidance Substance Over... other than tax avoidance Substance Over Form Doctrine - IRS can look through legal formalities to determine economic substance Step Transaction Doctrine - IRS can collapse a series of transactions into one Rule of thumb transactions more than a year are presumed to be independent Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 ... year PV of after -tax value of $70 x 0.909 = $ 64 WORSE c) Taxpayer can delay $100 income by one month but delay tax effect by one year PV of pre -tax value = $100 x 0.99 = 99 PV of tax cost... Companies, Inc., 2000 Income Tax Planning - Time and Tax Rate Changes Slide 4- 11 Suppose in c), Congress changes the tax law to increase the tax rate to 35% Then, the PV of pre -tax income is still...Objectives Slide 4- 2 Tax avoidance versus tax evasion Tax planning variables The Entity The Time Period The Jurisdiction The Character of Income Explicit and implicit taxes Tax law doctrines