Chapter 04 - Maxims of Income Tax Planning

Chapter 4 Maxims of Income Tax Planning

Questions and Problems for Discussion 1. a. Mr. L is engaging in tax evasion because he is deliberating understating income (and thus his tax liability) for the year. b. Mr. P is engaging in tax avoidance. He has not earned any income that he fails to report. Instead, he is giving his son an opportunity to earn income that will be taxed at a lower marginal rate than if Mr. P earned it. c. Mrs. Q is engaging in tax evasion because she is deliberately violating the rule requiring taxpayers to report and pay tax on income in the proper year. She is filing her prior year return based on false information (the year of sale).

6.

a. The corporations marginal rate is 15 percent. b. The corporations marginal rate is 39 percent. c. The individuals marginal rate is 25 percent.

d. The individuals marginal rate is 39.6 percent. 9. Income and deduction shifts usually require a corresponding shift in cash flow. Unless the economic consequences of the shift are neutral, the party with the reduced cash flow would not agree to the income/deduction shift. In a related party transaction, the party that reduces its cash flow because of the shift continues to benefit from the cash indirectly. For example, a parent that shifts income to a child may have less cash flow but benefits to the extent the child becomes financially independent.

12. Every tax planning strategy is based on a set of assumptions about the future. The more uncertain the assumptions, the more likely that the strategy will not produce the desired tax outcome. If the strategy cant be modified or undone at a reasonable cost and the assumptions prove to be inaccurate, the strategy may have undesirable tax consequences that the firm cant avoid. 13. a. Firms might accelerate income and postpone deductions to increase current income subject to the low tax rates (and reduce future income subject to the new, higher tax rates). b. Firms that implement this strategy are accelerating, rather than deferring, the payment of income tax, thereby increasing the cost of the tax in present value terms.

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Chapter 04 - Maxims of Income Tax Planning Application Problems 3. a. The income tax savings equals $4,699 ($19,100 shifted income 24.6% difference between Alisons marginal rate and Ms. JKs marginal rate). b. Ms. JKs gift of the interest coupon does not shift the income represented by the coupon to Alison because Ms. JK retains the bond. Therefore, the gift does not result in any income tax savings. c. Ms. JKs gift of the rent check does not shift the income represented by the check to Alison because Ms. JK retains the rental property. Therefore, the gift does not result in any income tax savings. The income tax savings equals $3,272 ($13,300 shifted income 24.6% difference between Alisons marginal rate and Ms. JKs marginal rate).

7.

If Firm M engages in the transaction, the annual after-tax profit is $6,600 ($10,000 before-tax profit $3,400 tax cost at 34 percent). If the transaction is restructured to shift the income to Firm N, the annual after-tax profit is $6,750 ($9,000 before-tax profit $2,250 tax cost at 25 percent). Therefore, Firm M should restructure the transaction to maximize after-tax profit.

9.

Original transaction: Taxable income Tax at 34% Before-tax cash flow Tax cost Net cash flow NPV Restructured transaction: Taxable income Tax at 34% Before-tax cash flow Tax cost Net cash flow Discount factor (10%) Present value NPV

Year 0 $100,000 $34,000 $100,000 (34,000) $66,000 $66,000 Year 0 Year 1 $50,000 $17,000 $100,000 -0$100,000 $100,000 $70,505 -0(17,000) $(17,000) .909 $(15,453) Year 2 $50,000 $17,000 -0(17,000) $(17,000) .826 $(14,042)

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Chapter 04 - Maxims of Income Tax Planning 10. Restructured transaction: Taxable income Tax Before-tax cash flow Tax cost Net cash flow Discount factor (10%) Present value NPV 12. Province P: Sale price per bike Manufacturing cost per bike Taxable income Tax ($188 20%) After-tax profit per bike Province W: Sale price per bike Manufacturing cost per bike Taxable income Tax ($170 16%) After-tax profit per bike. $100,000 -0$100,000 $100,000 $68,440 Year 0 Year 1 $50,000 $17,000 -0(17,000) $(17,000) .909 $(15,453) Year 2 $50,000 $19,500 -0(19,500) $(19,500) .826 $(16,107)

$400 (212) $188 (38) $150 $400 (230) $170 (27) $143

Company EJ should build its new plant in Province P to maximize after-tax profit per bike.

14. a. Mr. Gs before-tax and after-tax yield on the tax-exempt bonds is 3.5 percent. His after-tax yield on the corporate bonds is 3.18 percent (4.75% before-tax yield [4.75% 33% marginal tax rate]). Therefore, he should invest in the municipal bonds. b. In this case, Mr. Gs after-tax yield on the corporate bonds is 4.038 percent (4.75% beforetax yield [4.75% 15% marginal tax rate]). Therefore, he should invest in the corporate bonds.

19. Business operated by Firm W: After-tax cash flow at 34% tax rate Discount factor (6%) Present value NPV Business operated by Entity N: After-tax cash flow at 25% tax rate Cost of forming Entity N Net cash flow Discount factor (6%) Present value NPV

Year 0 $26,400 $26,400 $74,791 Year 0 $30,000 (5,000) $25,000 $25,000 $79,990

Year 1 $26,400 .943 $24,895

Year 2 $26,400 .890 $23,496

Year 1 $30,000 $30,000 .943 $28,290

Year 2 $30,000 $30,000 .890 $26,700

Firm W maximizes NPV by forming Entity N to operate the business.

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Chapter 04 - Maxims of Income Tax Planning Issue Recognition Problems 2. Does the tax benefit of operating in Country B rather than Country C justify the risk of operating in a unstable political and financial environment? To what extent would the before-tax rate of return on the manufacturing plant in Country B be reduced because of the unstable political and financial environment? Do the payments from Dr. Ps patients to his daughter shift income from Dr. P to the daughter? Who must report and pay tax on the income represented by the payments to the daughter? Does Dr. Ps tax strategy violate the assignment of income doctrine? What is the probability that the $27 market price will hold stable until January? Is Mrs. Y willing to accept the market risk inherent in the two-month delay to defer tax on her gain for one year? Does the sale of land by Corporation Q to its subsidiary have an independent business purpose or was the sole reason for the sale to accelerate Qs gain into the current year? If the IRS audits the tax returns reflecting the two sales, could it collapse the two transactions into a single sale of the land by Q to the unrelated buyer that occurred in February of the next year?

3.

4.

5.

Research Problems 3. This research case illustrates how judicial decisions depend on the unique facts and circumstances of each taxpayers situation. It also emphasizes the subjectivity of the distinction between tax avoidance and tax evasion.

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Chapter 04 - Maxims of Income Tax Planning Tax Planning Cases

2.

If DFG operates in Country X, the NPV of the operation (ignoring terminal value) is computed as follows. Annual before-tax profit Gross receipts tax ($110,000 3%) Annual after-tax profit After-tax profit in Year 0 NPV of after-tax profit in Years 1-9 ($24,700 5.759 discount factor) NPV $28,000 (3,300) $24,700 $24,700 142,247 $166,947

If DFG operates in Country Y, the NPV of the operation (ignoring terminal value) is computed as follows. Annual after-tax profit in Years 0-2 Annual before-tax profit in Years 3-9 Net income tax ($35,000 42%) Annual after-tax profit $35,000 $35,000 (14,700) $20,300

After-tax profit in Year 0 $35,000 NPV of after-tax profit in Years 1 and 2 ($35,000 1.736 discount factor) 60,760 NPV of after-tax profit in Years 3-9 ($20,300 4.868 discount factor) .826 discount factor 81,626 NPV $177,386

DFG should locate the subsidiary in Country Y to maximize NPV.

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Chapter 04 - Maxims of Income Tax Planning 3. Investment 1: Initial cash outlay in Year 0 Annual after-tax income/cash flow: Before-tax cash flow $8,000 Tax at 35% (2,800) Annual fee (nondeductible) (200) $5,000 Present value of cash flows: Year 1 ($5,000 .917 discount rate) Year 2 ($5,000 .842 discount rate) Year 3 ($55,000 .772 discount rate) NPV Investment 2: Initial cash outlay in Year 0 $(50,000) Sale in Year 3: Capital gain on sale $25,000 Preferential tax rate .15 Tax $3,750 NPV of cash flow in Year 3: ($71,250 after-tax cash .772 discount rate) 55,005 NPV $5,005 Investment 2 has the greater NPV. $(50,000)

4,585 4,210 42,460 $1,255

4.

If DC Company sells the land to Mrs. O this year, it will realize $693,500 after-tax cash. Cash proceeds from sale Tax cost: Sales proceeds DC's investment in the land Profit on sale $785,000 $785,000 (480,000) $305,000 .30 (91,500) $693,500 DC's alternative is to reject Mrs. O's offer and hope to sell the land at its appraised FMV next year. In this case, DC will realize only $672,000 after-tax cash. Cash proceeds from sale Tax cost: Sales proceeds DC's investment in the land Profit on sale $800,000 $800,000 (480,000) $320,000 .40 (128,000) $672,000 Even ignoring the fact that DC will receive the cash next year, this alternative results in less after-tax cash. Consequently, it should accept Mrs. Os offer.
2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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Chapter 04 - Maxims of Income Tax Planning

2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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