Chapter4MaximsofIncomeTaxPlanning

Chapter 4
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).

2.

Because the preferential tax rate increases the after-tax rate of return on investments in singlefamily rental houses, the value of such houses should increase compared to the value of other
investments until the after-tax rate of return decreases to restore market equilibrium.

3.

Because of the time value of money, the cost of a tax dollar paid in the future is less than the
cost of a current tax dollar. If a tax payment can be postponed for many years, its cost in present
value terms may be negligible.

4.

As a general rule, the measurement of business income is not affected by the choice of entity
form. Mrs. Ks business operation should generate the same taxable income regardless of its
organization as a sole proprietorship or as a corporation.

5.

Businesses organized as sole proprietorships, partnerships, limited liability companies (LLCs),

and S corporations are not taxable entities. Only businesses organized as corporations are
taxable entities separate and distinct from their owners.

6.

a. The corporations marginal rate is 15 percent.

b. The corporations marginal rate is 39 percent.
c.

The individuals marginal rate is 30 percent.

d. The individuals marginal rate is 35 percent.

7.

a. If the tax rate is truly flat (every dollar of business income is taxed at the same rate,
regardless of the entity earning the dollar), the entity variable would be irrelevant in
developing tax planning strategies.
b. A flat tax rate would not affect the time period variable.
c.

A flat federal income tax rate would not affect the jurisdictional variable because state and
local governments and foreign taxing jurisdictions would impose different rates on taxable
income.

d. If the tax rate is flat, no special category of income is subject to a preferential rate. However,
other special characteristics (such as the U.S. source versus foreign source characteristic)
might continue to be important in developing tax planning strategies.

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Chapter4MaximsofIncomeTaxPlanning
8.

a. In this case, the rates are relatively low and mildly progressive. A shift of $100 income from
an entity with the highest 19 percent marginal rate to an entity with the lowest 5 percent
marginal rate saves only $14 of tax.
b. Because the rates are much more progressive than in the preceding set of facts, an income
shift is more beneficial. A shift of $100 income from an entity with the highest 50 percent
marginal rate to an entity with the lowest 10 percent marginal rate saves $40 of tax.
c.

9.

With a proportionate rate structure, an income shift from one entity to another yields no tax
benefit.

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.

10. Corporation Ps income shift to Subsidiary S suggests that its marginal tax rate is less than 25
percent. The deduction shift to Subsidiary T suggests that its marginal tax rate is more than 25
percent.
11. Delay of the receipt of $25,000 for five months (August to January) has a higher opportunity cost
than delay of the receipt of $25,000 for one month (December to January). Evidently, Firm A
concluded that the opportunity cost of the deferral of the August income item exceeded the tax
savings from the corresponding tax deferral.
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.
14. a. Mr. Ts current marginal tax rate (as a student) may be significantly lower than his marginal
rate in five years (as a practicing attorney). The additional tax cost from the rate increase will
certainly reduce (and may even exceed) the tax savings from the deferral.
b. Mr. Ts current marginal tax rate (as a senior employee) may be significantly higher than his
marginal rate in five years (as a retiree). The additional tax savings from the rate decrease
will add to the tax savings from the deferral.

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Chapter4MaximsofIncomeTaxPlanning
Application Problems
1.

a. Tax liability $7,245; marginal rate 15%; average rate 15%.

b. Tax liability $209,372; marginal rate 34%; average rate 34%.
c.

Tax liability $5,533,800; marginal tax rate 38%; average tax rate 34.56%.

d. Tax liability $13,738,550; marginal rate 35%; average rate 35%.

2.

a. Tax liability $7,003; marginal rate 15%; average rate 13.49%.

b. Tax liability $47,514; marginal rate 33%; average rate 25.52%.
c.

3.

Tax liability $132,166; marginal rate 35%; average rate 29.61%.

a. The income tax savings equals $3,820 ($19,100 shifted income 20% 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.

4.

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 $1,180 ($5,900 shifted income 20% difference between
Alisons marginal rate and Ms. JKs marginal rate).

a. If Firm A incurs the $9,500 expense, the after-tax cost is $8,075 ($9,500 $1,425 tax
savings at 15 percent).
b. If Firm Z incurs the $9,500 expense, the after-tax cost is $6,840 ($9,500 $2,660 tax
savings at 28 percent).

5.

a. $85,000 cash receipt $25,500 tax (30%) = $59,500

b. $85,000 cash receipt $3,060 tax (12%) = $74,800
c.

Under the assignment of income doctrine, the $85,000 income generated by the service
contract must be taxed to Company G because Company G performed the services.
Therefore, Company G must pay $25,500 tax (negative cash flow), even though Company J
receives the $85,000 cash.

6.

BPKs after-tax cost of a $72,000 deductible expense is $54,000 ($72,000 before-tax cost
$18,000 tax savings at 25 percent). OPKs after-tax cost of a $92,500 deductible expense is
$55,500 ($92,500 before-tax cost $37,000 tax savings at 40 percent). Therefore, BPK should
incur the expense to minimize its after-tax cost.

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.

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Chapter4MaximsofIncomeTaxPlanning
8.

a.
Before-tax cash flow/
taxable income
Tax cost at 30%
After-tax cash flow
Discount factor (7%)
Present value
NPV

Year 0

Year 1

Year 2

Year 3

$12,000
(3,600)
$8,400

$21,000
(6,300)
$14,700
.935
$13,745

$24,000
(7,200)
$16,800
.873
$14,666

$17,600
(5,280)
$12,320
.816
$10,053

Year 0

Year 1

Year 2

Year 3

-0-

-0-

$57,000
(17,100)
$39,900
.873
$34,833

$17,600
(5,280)
$12,320
.816
$10,053

Year 2

Year 3

$24,000
(17,100)
$6,900
.873
$6,024

$17,600
(5,280)
$12,320
.816
$10,053

Year 1

Year 2

$50,000
$17,000

$50,000
$17,000

-0(17,000)
$(17,000)
.909
$(15,453)

-0(17,000)
$(17,000)
.826
$(14,042)

$8,400
$46,864

b.
Before-tax cash flow/
taxable income
Tax cost at 30%
After-tax cash flow
Discount factor (9%)
Present value
NPV

$44,886

c.

9.

Year 0

Year 1

Before-tax cash flow

Tax cost at 30%
After-tax cash flow
Discount factor (9%)
Present value

$12,000

$21,000

$12,000

$21,000
.935
$19,635

NPV

$47,712

$12,000

Original transaction:

Year 0

Taxable income
Tax at 34%

$100,000
$34,000

Before-tax cash flow

Tax cost
Net cash flow

$100,000
(34,000)
$66,000

NPV
Restructured transaction:

$66,000
Year 0

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

$100,000
-0$100,000
$100,000
$70,505

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Chapter4MaximsofIncomeTaxPlanning
10. Restructured transaction:

Year 0

Taxable income
Tax
Before-tax cash flow
Tax cost
Net cash flow
Discount factor (10%)
Present value

$100,000
-0$100,000
$100,000

NPV

Year 1

Year 2

$50,000
$17,000

$50,000
$19,500

-0(17,000)
$(17,000)
.909
$(15,453)

-0(19,500)
$(19,500)
.826
$(16,107)

$68,440

11. Original structure of transaction:

Year 0
Cash received
Tax cost ($200,000 income 35%)
Net cash flow

$200,000
(70,000)
$140,000

Year 1
Cash received
Tax cost ($160,000 income 35%)
Net cash flow
Discount factor (8%)
Present value of year 1 cash flow

$160,000
(56,000)
$104,000
.926
$96,304

$140,000 + $96,304 = $236,304 NPV

Restructured transaction:
Year 0
Cash received
Tax cost ($375,000 income 35%)
Net cash flow

$215,000
(131,250)
$83,750

Year 1
Cash received
Tax cost
Net cash flow
Discount factor (8%)
Present value of year 1 cash flow

$160,000
0
$160,000
.926
$148,160

$83,750 + $148,160 = $231,910 NPV

Corporation R should not agree to restructure the transaction because restructuring would
reduce NPV.
12. Province P:
Sale price per bike
Manufacturing cost per bike
Taxable income
Tax ($188 20%)
After-tax profit per bike

$400
(212)
$188
(38)
$150

Province W:
Sale price per bike
Manufacturing cost per bike
Taxable income
Tax ($170 16%)
After-tax profit per bike.

$400
(230)
$170
(27)
$143

Company EJ should build its new plant in Province P to maximize after-tax profit per bike.
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Chapter4MaximsofIncomeTaxPlanning
13. a.

State tax computation:

Pretax income
Deduction for foreign tax
State taxable income
State tax
Federal tax computation:
Pretax income
Deduction for foreign tax
Deduction for state tax
Federal taxable income
Federal tax

$2,738,000
(97,300)
$2,640,700
.06
$158,442
$2,738,000
(97,300)
(158,442)
$2,482,258
.34
$843,968

Motos total tax burden is $1,099,710 ($97,300 foreign + $158,442 state + $843,968
federal).
b.

State tax computation:

State taxable income
State tax
Federal tax computation:
Pretax income
Deduction for foreign tax
Deduction for state tax
Federal taxable income
Federal tax

$2,738,000
.06
$164,280
$2,738,000
(97,300)
(164,280)
$2,476,420
.34
$841,983

Motos total tax burden is $1,103,563 ($97,300 foreign + $164,280 state + $841,983
federal).
c.

State tax computation:

State taxable income
State tax
Federal tax computation:
Pretax income
Deduction for state tax
Federal taxable income
Federal tax

$2,738,000
.06
$164,280
$2,738,000
(164,280)
$2,573,720
.34
$875,065

Motos total tax burden is $1,136,645 ($97,300 foreign + $164,280 state + $875,065
federal).
14. a. Mr. Gs before-tax and after-tax yield on the tax-exempt bonds is 7 percent. His after-tax
yield on the corporate bonds is 6.365 percent (9.5% before-tax yield [9.5% 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 8.075 percent (9.5% before-tax
yield [9.5% 15% marginal tax rate]). Therefore, he should invest in the corporate bonds.
15. The value of the preferential rate is $650 ($5,000 income 13% excess of ordinary rate over
preferential rate).

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Chapter4MaximsofIncomeTaxPlanning
16. a. Mr. L paid a $1,000 implicit tax ($6,000 return that Mr. L could have earned $5,000 return
he accepted to receive a preferential tax rate).
b. Mr. Ls after-tax return on his investment was $4,250 ($5,000 return $750 tax). His after-tax
return from the business would have been $4,320 ($6,000 return $1,680 tax). Therefore,
he made an incorrect investment decision. Another way to reach the same conclusion is to
compare Mr. Ls $1,000 implicit tax on his investment with the $650 value of the preferential
rate on that investment.
17. a. Ms. A will save $1,200 ($8,000 15% rate decrease).
b. Mr. B will save $1,950 ($15,000 13% rate decrease).
c.

Mr. C not save any tax because of the new preferential rate.

d. Mrs. D will save $5,600 ($70,000 8% rate decrease).

18. a. Firm L pays $22,750 explicit tax and no implicit tax on Investment A and no explicit tax and
$17,500 implicit tax on investment B. The implicit tax is the $17,500 difference between the
before-tax rates of return on the taxable investment and the tax-exempt investment.
b. Because the explicit tax on Investment A exceeds the implicit tax on Investment B, Firm L
should invest in the latter. Investment A results in $42,250 after-tax cash flow ($65,000
$22,750 explicit tax), while Investment B results in $47,500 after-tax cash flow.
19. Business operated by Firm W:

Year 0

Year 1

Year 2

After-tax cash flow at 34% tax rate

Discount factor (6%)
Present value

$26,400

$26,400
.943
$24,895

$26,400
.890
$23,496

NPV

$74,791
Year 1

Year 2

$30,000

$30,000

$30,000
.943
$28,290

$30,000
.890
$26,700

Business operated by Entity N:

$26,400

Year 0

After-tax cash flow at 25% tax rate

Cost of forming Entity N
Net cash flow
Discount factor (6%)
Present value

$30,000
(5,000)
$25,000

NPV

$79,990

$25,000

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

Issue Recognition Problems
1.

Do Mr. and Mrs. TR have the same marginal tax rate as Ms. K? Would Mr. and Mrs. TR pay
implicit tax on an investment in Ms. Ks tax-preferred business (in the form of a reduced beforetax rate of return) that exceeds the explicit tax on their current investment?

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?

3.

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?

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Chapter4MaximsofIncomeTaxPlanning
4.

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?

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Chapter4MaximsofIncomeTaxPlanning
5.

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?

6.

Does the gift of the rent checks shift rent income from Mr. and Mrs. K to their grandson? Who
must report and pay tax on the income represented by the rent checks?

7.

What is the probability that the IRS will audit the tax returns reflecting Firm Zs aggressive
strategy? How frequently has the IRS audited Firm Z in the past? If the IRS does disallow the
intended tax outcome of the aggressive strategy, can Firm Z alter or reverse the strategy at a
reasonable cost? If Firm Z can alter or reverse the strategy, will before-tax cash flows increase?

8.

Could the IRS invoke the substance-over-form doctrine to require Ms. LG to report the
transaction as a lease rather than as a sale? If Ms. LGs tax position does change, can she
invoke this doctrine by ignoring the legal form of the transaction (which she deliberately
structured as a sale) and treat it as a lease for tax purposes?

9.

Will Firm HR reduce its exposure to the step-transaction doctrine by delaying the second phase
of its business strategy from August to January? What are the nontax costs of the delay?

Research Problems
1.

This research case provides students with practice in conducting a key-word search (step
transaction) in a particular electronic data base (federal judicial decisions).

2.

This research case provides students with practice in briefing a judicial decision.

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.

Tax Planning Cases

1. If Ms. Z invests in the State A bonds, her before- tax and after-tax return is $3,750 ($75,000
5%). If she invests in the state R bonds, her after-tax return is computed as follows.
Before-tax return ($75,000 5.4%).
State A income tax ($4,050 interest 8.5%)
Federal tax savings from deduction of
state income tax ($344 33%)
After-tax return

$4,050
(344)
114
$3,820

Therefore, Ms. Z should invest in the State R bonds to maximize her after-tax return.

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Chapter4MaximsofIncomeTaxPlanning
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

$28,000
(3,300)
$24,700

After-tax profit in Year 0

$24,700
NPV of after-tax profit in Years 1-9
($24,700 5.759 discount factor)
142,247
NPV
$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

$35,000

Annual before-tax profit in Years 3-9

Net income tax ($35,000 42%)
Annual after-tax profit

$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.
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

$(50,000)

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

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.

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Chapter4MaximsofIncomeTaxPlanning
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.

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