The income-shifting strategy requires taxpayers with varying tax rates.

Why is the goal of tax planning not simply to minimize taxes?

1. In general, the primary goal of tax planning is to maximize after tax wealth while simultaneously achieving the taxpayer's nontax goals.

2. Maximizing after-tax wealth is not necessarily the same as tax minimization

3. Maximizing after-tax wealth requires one to consider both the tax and nontax costs and benefits of alternative transactions, whereas tax minimization focuses solely on a single cost(taxes).

Describe the three parties engaged in every business transaction and how understanding taxes may aid in structuring transactions.

1. Three parties involved are the taxpayer, the other transacting party, and the government(specifies tax consequences of transactions).

2. Effective tax planning requires an understanding of the tax and nontax costs from the taxpayer's and the other party's perspectives because tax and nontax factors also influence the other party's preferences.

3. Understanding these preferences will allow the taxpayer to identify an optimal transaction structure.

Three basic tax planning strategies and the different features of taxation they exploit.

1. Timing strategy exploits the variation in taxation across time: the real tax costs of income decrease as taxation is deferred; the real tax savings associated with tax deductions increase as tax deductions are accelerated.

2. Income shifting strategy exploits the variation in taxation across taxpayers.

3. Conversion strategy exploits the variation in taxation across activities.

What are the two basic timing strategies? What is the intent of each

1. Two timing strategies are deferring taxable income and accelerating tax deductions.

2. Intent of deferring taxable income recognition is to minimize the present value of taxes paid.

3. Intent of accelerating tax deductions is to maximize the present value of tax savings from the deductions.

Why is the timing strategy particularly effective for cash-method taxpayers?

Because deduction year for cash-method taxpayers depends on when the taxpayer pays the expense(which the taxpayer controls).

What are some common examples of the timing strategy?

1. Important aspect of investment planning, retirement planning, and property transactions.

2. Also an important aspect of tax planning for everyday business operations(e.g., determining appropriate period to recognize sales income).

3. Common examples include accelerating depreciation, deductions for depreciable assets, using LIFO versus FIFO for inventory, accelerating the deduction of certain prepaid expenses, etc.

What factors increase the benefits of accelerating deductions or deferring income?

1. Higher tax rates, higher interest rates, larger transaction amounts, and the ability to accelerate deductions by two or more years increase the benefits of accelerating deductions.

2. Higher tax rates, higher interest rate, larger transaction amounts, and the ability to defer revenue recognition for longer periods of time increase the benefits of income deferral.

How do changing tax rates affect the timing strategy? What information do you need to determine the appropriate timing strategy when tax rates change?

1. When tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions will now vary.

2. The higher the tax rate, the higher the tax savings for a tax deduction.

3. The lower the tax rate, the lower the tax costs for taxable income.

4. All things being equal, taxpayers, should prefer to recognize deductions during high tax-rate years and income during low-tax rate years.

5. Before implementing timing strategy, potential tax rate changes should be considered.

6. Increasing tax rates may actually result in taxpayers preferring to accelerating income and defer deductions.

7. To determine appropriate strategy when tax rates change, you need the taxpayer's after-tax rate of return and the amount of the tax rate increase.

Timing Strategy limitations

1. Several inherent limitations.

2. Generally speaking, when a taxpayer is unable to accelerate a deduction without also accelerating the cash outflow, the timing strategy will be less beneficial.

3. Tax law generally requires taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes.

4. A deferral strategy may not be optimal if:
a. taxpayer has severe cash flow needs
b. if continuing the investment would generate a low rate of return compared to other investments
c. if the current investment would subject the taxpayer to unnecessary risk

5. Constructive receipt doctrine(taxpayer must recognize income when it is actually or constructively recieved) restricts income deferral for cash-method taxpayers.

Why is understanding the time value of money important for tax planning

1.Taxes paid are cash outflows, and tax savings generated from tax deductions can be thought of as cash inflows.

2. Timing of when a taxpayer pays tax on income or receives a tax deduction for an expenditure affects the present value of the taxes paid (cash outflow) or tax savings received(cash inflow).

What two factors increase difference between present and future values?

The rate of return and the investment period.

What factors have to be present for income shifting to be a viable strategy?

1. Legitimate method of shifting income that will withstand IRS scrutiny

2a. Related parties, such as family member or businesses and their owners, who have varying marginal tax rates and are willing to shift income for the benefit of the group

2b. taxpayers operating in multiple jurisdictions with different marginal tax rates.

Three common types of income shifting

1. income shifting from high tax rate parents to low tax rate children

2. Income shifting from businesses to their owners.

3. taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions.

What are some ways that a parent could effectively shift income to a child? What are some of the disadvantages of these methods?

1. Parents who own a business may shift income to their children by employing them to work for the business:

a. Since it's a related party transaction, the substance of the transaction must be justifiable, not just the form.

b. Disadvantage is that it requires children to actually perform services for the parent's business, which may or may not be a positive factor given the skill set of the children and the ability of the family to work together in harmony.

2. Parents may also shift investment income to their children by transferring the underlying investments to the children. Disadvantages of this method:
a. Parents may not to be able to afford to transfer significant wealth to their children or would have serious reservations about doing so.
b. Kiddie tax may apply if parents shift too much investment income to children.
c. Kiddie tax restricts the amount of a child's investment income that can be taxed at the child's(lower) tax rate instead of the parent's(higher) tax rate.

Key factor in shifting income from a business to its owners? Methods of shifting income in this context?

1. To shift income from the corporation to the owner, the transaction must generate a tax deduction to the corporation.

2. Compensation paid to employee-owners is the most common method of shifting income from corporation to their owners.

3. Compensation expense is tax deductible by the corporation and is generally taxable to the employee.

4. Business owner renting property or loaning money to corporation are other effective income shifting methods because of its tax deductible to corporations and income for the shareholder.

5. Since corporations do not get tax deductions for dividends paid, paying dividends is not an effective way to shift income, but it instead results in double taxation.

Why is paying dividends not an effective way to shift income from a corporation to its owners

1. Corporations do not get a tax deduction for dividends paid.

2. Results in double taxation.

3. Profits generating dividends are taxed first at the corporate level, and then dividends are taxed at the shareholder level.

Conversion strategy examples

1. investment planning and the advantages of investing in assets that generate preferentially taxed income.

2. Basic differences between business and investment activities and what traits result in the more favorable "business" designation for expense deductions.

3. Compensation planning and the benefits of restructuring employee compensation from currently taxable compensation to nontaxable or tax deferred forms of compensation, such as employer-provided health insurance and retirement contributions.

What is needed to implement the conversion strategy

1. One must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities.

2. Have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment.

How might implicit taxes limit the benefits of the conversion strategy?

1. The concept of implicit taxes suggests that the demand for tax advantaged activities increases the costs associated with these activities, thereby reducing the pretax returns of these activities and the advantages of the conversion strategy.

2. May reduce or eliminate advantages for tax-preferred investments, such as municipal bonds, by decreasing the pretax rate of returns for these investments.

Do after-tax rates of return for investments in either interest or dividend paying securities increase with the length of investment?

They do not because they are both taxed annually.

Takeaway from question 23

1. The longer the tax is deferred, the less it costs on an after-tax basis.

2. The lower the tax cost, the higher the after-tax return, all else equal.

Take away from Question 24

The after-tax return of capital assets approaches the after-tax return of tax-exempt assets, the longer the taxpayer holds the capital assets.

The longer the taxpayer holds the capital asset before selling, the less the tax costs in PV terms.

How do changing tax rates affect the timing strategy?

Which of the following strategies explains the fact that tax rates vary by activity?

Which of the following does not limit the income shifting strategy?

Which of the following is an example of a tax avoidance strategy?