Chapter 3: Tax Planning Strategies and Related Limitations

Question 0

What three parties are involved in tax transactions?

Answer 0

The taxpayer, the other transacting party (employer) and the government (silent party who specifies the tax consequences of the transaction)

Question 1

What is the goal of effective tax planning?

Answer 1

maximizing the taxpayer’s after tax wealth while achieving the taxpayer’s nontax goals

Question 2

What are the three building blocks of tax planning?

Answer 2

Timing
Income shifting
Conversion

Question 3

What is a discount factor?

Answer 3

A factor based on the taxpayer’s rate of return that is used to determine the present value of future cash inflows (tax savings) and outflows (taxes paid)

Question 4

What is the present value of money?

Answer 4

PV= FV / (1 + r)^n
the concept that $1 today is worth more than $1 in the future.

FV= PV x (1 + r)^n
when considering cash inflows, higher present values are preferred
when considering cash outflows, lower present values are preferred

Question 5

What is the general rule of thumb that financial planners always keep mind?

Answer 5

When considering cash inflows, prefer higher present values

When considering cash outflows, prefer lower present values

Question 6

What is a discount factor?

Answer 6

a factor that is very useful for calculating the present value of future inflows or outflows of cash. This factor is derived from the taxpayer’s expected after-tax rate of return

Question 7

What are the two basic tax-related timing strategies when tax rates are constant?

Answer 7

Accelerate tax deductions (deduct in an earlier period)

Defer recognizing taxable income (recognize in a later period)

Question 8

What is the general idea of accelerate tax deductions?

Answer 8

tax savings received now have a higher present value than the same amount received a year from now. The intent of the timing strategy is to accelerate the tax deduction significantly without accelerating the actual cash outflow that generates the expense

Question 9

What is the general idea of Deferring taxable income?

Answer 9

Taxes paid a year from now have a lower present value than taxes paid today?

Question 10

When tax rates change what should the timing strategy be?

Answer 10

When tax rates are higher, savings for a tax deduction is higher. Meaning that you want to find more deductions to decrease income when taxes are high. The lower the tax rate, the lower the tax costs for taxable income

Question 11

What are the limitations of timing strategies?

Answer 11

Timing strategies to defer income or accelerate deductions is less beneficial if the acceleration of a deduction also accelerates cash outflow.
That income must be recognized when earned
Tax laws require tax payers to continue investments in an asset in order to defer income recognition for tax purposes.

Question 12

What is the constructive receipt doctrine?

Answer 12

The judicial doctrine that states a taxpayer must recognize income when it is actually or constructively received. This doctrine is deemed to have occurred if the income has been credited to the taxpayer’s account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability and there are not restrictions on the taxpayer’s control over the income

Question 13

What is the assignment of income doctrine?

Answer 13

The judicial doctrine holding that earned income is taxed to the taxpayer providing the service, and that income from property is taxed to the individual who owns the property when the income accrues

Question 14

What is a related party transaction?

Answer 14

financial activities among family members, among owners and their businesses, or among businesses owned by the same owners

Question 15

What are arm’s length transactions?

Answer 15

transactions among unrelated taxpayers, where each transacting party negotiates for his or her own benefit

Question 16

What is the Income shifting strategy?

Answer 16

Income shifting exploits the differences in tax rates across taxpayers or jurisdictions.
Examples of income shifting transactions are high tax rate parents shifting income to lower tax rate children.
The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns the income

Question 17

What is the conversion strategy?

Answer 17

Based on the understanding that the tax law does not treat all types of income or deductions the same
To implement the conversion strategy one must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment

Question 18

What are two examples of the conversion strategy?

Answer 18

Investment planning that exploits the advatages of investing in assets that generate prefentially taxed income and compensation planning that restructures employee compensation from currently taxable compensation to nontaxable or tax deferred forms of compensation, such as employer provided health insurance and retirement contributions

Question 19

What is the business purpose doctrine?

Answer 19

This judicial doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation

Question 20

What is the Step-transaction doctrine?

Answer 20

The judicial doctrine that allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction

Question 21

What is the economic substance doctrine?

Answer 21

The judicial doctrine that requires transactions to meaningfully change taxpayer’s economic position and to have a substantial purpose (apart from a federal income tax purpose) in order for a taxpayer to obtain tax benefits

Question 22

What is tax avoidance?

Answer 22

The legal act of arranging one’s transactions or affairs to reduce taxes paid.

Question 23

What is tax evasion?

Answer 23

The willful attempt to defraud the government. Tax evasion falls outside the confines of legal tax avoidance

Question 24

When does tax avoidance become tax evasion?

Answer 24

In order to determine if a transaction is avoidance or evasion professional judgement, the use of a smell test and consideration of the business purpose, step-transaction, and substance-over-form doctrines may prove useful

Question 25

What is the constructive receipt doctrine?

Answer 25

A taxpayer must recognize income when it is actually or constructively received. This has occurred if the income has been credited to the taxpayer’s account of if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income