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

difference in tax

rates

depends on the 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.