Identify the objectives of basic tax planning strategies.
Effective tax planning maximizes the taxpayer's after-tax wealth while achieving the taxpayer's nontax goals. Maximizing after-tax wealth is not necessarily the same as tax minimization. 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 (i.e., taxes).
Virtually every transaction involves three parties: the taxpayer, the other transacting party, and the uninvited silent party that specifies the tax consequences of the transaction (i.e., the government). Astute tax planning requires an understanding of the tax and nontax costs from the taxpayer's and the other party's perspectives.
Apply the timing strategy and describe its applications and limitations.
One of the cornerstones of basic tax planning involves the idea of timing—that is, when income is taxed or an expense is deducted affects the associated "real" tax costs or savings. This is true for two reasons. First, the timing of when income is taxed or an expense is deducted affects the present value of the taxes paid on income or tax savings on deductions. Second, the tax costs of income and tax savings income vary as tax rates change.
When tax rates are constant, tax planners prefer to defer income (i.e., to reduce the present value of taxes paid) and accelerate deductions (i.e., to increase the present value of tax savings). Higher tax rates, higher rates of return, larger transaction amounts, and the ability to accelerate deductions or defer income by two or more years increase the benefits of the timing strategy.
When tax rates change, the timing strategy requires a little more consideration because the tax costs of income and the tax savings from deductions vary as tax rates change. When tax rates are increasing, the taxpayer must calculate the optimal tax strategies for deductions and income. When tax rates are decreasing, the recommendations are clear. Taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years.
Timing strategies contain several inherent limitations. Generally speaking, whenever a taxpayer must accelerate a cash outflow to accelerate a deduction, the timing strategy will be less beneficial. Tax law generally requires taxpayers to continue their investment in an asset in order to defer income recognition for tax purposes. A deferral strategy may not be optimal if the taxpayer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unnecessary risk, and so on. The constructive receipt doctrine, which provides that a taxpayer must recognize income when it is actually or constructively received, also restricts income deferral for cash-basis taxpayers.
Apply the concept of present value to tax planning.
The concept of present value—also known as the time value of money—basically states that $1 today is worth more than $1 in the future. For example, assuming an investor can earn a positive return (e.g., 5 percent after taxes), $1 invested today should be worth $1.05 in one year. Hence, $1 today is equivalent to $1.05 in one year.
The implication of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense.
Apply the strategy of income shifting, provide examples, and describe its limitations.
The income-shifting strategy exploits the differences in tax rates across taxpayers or jurisdictions. Three of the most common examples of income shifting are high-tax-rate parents shifting income to low-tax-rate children, businesses shifting income to their owners, and taxpayers shifting income from high-tax jurisdictions to low-tax jurisdictions.
The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns the income. In addition, the IRS closely monitors such related-party transactions—that is, financial activities among family members, among owners and their businesses, or among businesses owned by the same owners. Implicit taxes may also limit the benefits of income shifting via locating in tax-advantaged jurisdictions.
Apply the conversion strategy, provide examples, and describe its limitations.
Tax law does not treat all types of income or deductions the same. This understanding forms the basis for the conversion strategy—recasting income and expenses to receive the most favorable tax treatment. 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.
Common examples of the conversion strategy include investment planning to invest in assets that generate preferentially taxed income, compensation planning to restructure employee compensation from currently taxable compensation to nontaxable or tax-deferred forms of compensation, and corporate distribution planning to structure corporate distributions to receive the most advantageous tax treatment.
The Internal Revenue Code contains specific provisions that prevent the taxpayer from changing the nature of expenses, income, or activities to a more tax-advantaged status. Implicit taxes may also reduce or eliminate the advantages of conversion strategies.
Describe basic judicial doctrines that limit tax planning strategies.
The constructive receipt doctrine, which may limit the timing strategy, provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt 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 no restrictions on the taxpayer's control over the income.
The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns the income. The assignment of income doctrine implies that, in order to shift income to a taxpayer, that taxpayer must actually earn the income.
The business purpose, step-transaction, and substance-over-form doctrines apply across a wide variety of transactions and planning strategies (timing, income shifting, and conversion).
The business purpose doctrine allows the IRS to challenge and disallow business expenses for transactions with no underlying business motivation, such as a travel cost of a spouse accompanying a taxpayer on a business trip.
The step-transaction doctrine allows the IRS to collapse a series of related transactions into one transaction to determine the tax consequences of the transaction.
The substance-over-form doctrine allows the IRS to consider the transaction's substance regardless of its form, and where appropriate, reclassify the transaction according to its substance.
Contrast tax avoidance and tax evasion.
Tax avoidance is the legal act of arranging one's transactions, and so on, to minimize taxes paid. Tax evasion is the willful attempt to defraud the government (i.e., by not paying taxes legally owed). Tax evasion falls outside the confines of legal tax avoidance.
In many cases a clear distinction exists between avoidance (e.g., not paying tax on municipal bond interest) and evasion (e.g., not paying tax on a $1,000,000 game show prize). In other cases, the line between tax avoidance and evasion is less clear. In these situations, professional judgment, the use of a "smell test," and consideration of the business purpose, step-transaction, and substance-over-form doctrines may prove useful.