Chapter 3. Howard Godfrey, Ph.D., CPA

Professor of Accounting ©Howard Godfrey-2012

TAX REFUNDRevenue America News Release: September 22, 2011.

• Due to a very significant increase in tax collection for the year 2011, The United States Treasury Department and I.R.S. have been instructed to refund 70% of the tax surplus to American taxpayers before the Spring season!

• Average refund will be between $3000 to $6500 for a married couple, and $1500 to $3250 for a single person.

• Click on the red dot below to listen to the official proclamation and instructions as to how to apply for this refund online.

•

You Wish!!!!! You Wish!!!!!

Hit “Esc” key to exit.

Sincerely, The I.R.S.

3. Planning Strategies, Limits1. Objectives of tax planning.2. Timing strategy: applications, limits. Apply present value.3. Income shifting, examples, limits.4. Conversion strategy, examples, limits

5. Judicial doctrines that limit tax planning.6. Tax avoidance vs. tax evasion

Objective to minimize tax???Taxpayer (TP) is in the 30% marginal tax bracket in a state with no income tax.TP owns IBM bonds with face value of $200,000, earning interest at 5%. Total annual interest income is $10,000. TP pays federal income tax of $3,000 (30%).TP can avoid paying income tax on interest income by switching from the IBM bonds to N.C. bonds earning 3% ($6,000 per year).

Taxes and Cash Flow• Tax cost is the increase in tax for the

period and is a cash outflow• Tax saving is a decrease in tax for a

period and is a cash inflow–Expense payment generates an outflow,

but deduction generates a tax reduction–Reducing income taxes paid is a pure

cash inflow because tax savings are not taxable

Taxes and Cash Flows • Cash flows in future years are

discounted to their present value so they can be compared using comparable dollars

• When marginal tax rates are expected to change from year to year, timing of transactions should be controlled to minimize tax costs and maximize tax savings

Tax PlanningTax PlanningTax Evasion and Tax AvoidanceEthics in

Tax Practice

Example 3-3A calendar-year taxpayer uses the cash method for her small business. On December 28, 2011, she receives a $10,000 bill from her accountant for services. There is no late payment charge if the $10,000 bill is paid before January 10, 2012.Marginal tax rate is 30% this year and next.She can earn an after-tax rate of return of 10% on her investments. When should she pay the $10,000 bill-this year or next?

Answer: If Mercedes pays the bill this year, she will receive a tax deduction on the tax return for the current year. If she pays the bill in January, she will receive a tax deduction on tax return for following year (one year later). She needs to compare the after-tax cost of the accounting service using the present value of the tax savings for each scenario.

Example 3-3 Option 1: Option 2:

Pay $10,000 on Pay $10,000 Pay $10,000

12-31-2011 or 1-10-2012 this year next year

Tax deduction $10,000 $10,000Marginal tax rate (30%) 30% 30%Tax savings $3,000 $3,000

Discount factor (10%) 100% 90.9%P. V. tax savings $3,000 $2,727

After-tax cost of services: Before-tax cost $10,000 $10,000Less: P.V. tax savings ($3,000) ($2,727)

After-tax cost of services $7,000 $7,273Ignores use of use of funds - until January 10.

Example 3-4Bill will sell his Dell Inc. stock. Stock cost $20,000 ten years ago. Stock is now worth $100,000.Assume Bill's tax rate on the $80,000 gain will be 15%. His typical after-tax rate of return on investments is 7%.He plans to sell the stock on December 30, 2011. What effect would deferring the sale (until January 1, 2012) have on Bill's after-tax income on the sale?

Ex. 3-4. Should he sell stock: Option 1: Option 1: in Dec. 2011 or Jan. 2012? Sell in Sell in Cost: $20,000. FMV: $100,000. December JanuarySales price $100,000 $100,000 Less: Cost of stock ($20,000) ($20,000)Gain on sale $80,000 $80,000

Marginal tax rate 15% 15%Tax on gain 12,000 12,000

Discount factor -7% 100% 93.5%Present value tax cost 12,000 11,220After-tax income from sale:

Before-tax income $100,000 $100,000 Less: Present value tax cost ($12,000) ($11,220)After-tax income from sale $88,000 $88,780

Repeat preceding problem.What if the stock value is expected to drop from its current value of $100,000 to $99,000 when sold next year?

What if the income tax rate is expected to increase to 20% next year?

Example 3-5Mercedes will buy a machine in December 2011, and claim a corresponding $10,000 deduction for 2011 or buy the machine in January 2012. With the new machinery, business income will rise and the marginal rate will increase from 20% in 2011 to 28% in 2012. Her after-tax rate of return is 8%.

What should Mercedes do? Answer: Given rising tax rates, Mercedes should: 1. calculate the after-tax cost of the equipment for both options and 2. compare present values.

Example 3-5Buy machine in Dec. 2011 Buy Buyor in January 2012. this year next year

Machine Cost-Tax deduction $10,000 $10,000Marginal tax rate (20%, 28%) 20% 28%Tax savings $2,000 $2,800

Discount factor (8%) 100% 92.6%P.V. tax savings $2,000 $2,592.80

After-tax cost of machine: Before-tax cost $10,000 $10,000Less: P.V. tax savings ($2,000) ($2,593)

After-tax cost of Machine $8,000 $7,407

Income Spreading TP is in 40% income tax bracket. Son (an adult) is in 20% income tax bracket). TP owns ABC stock (bought on 1-05-2012). ABC stock has FMV of $100,000 ABC stock has cost of $20,000

Option 1. TP sells ABC stock today (12-28-2012).Option 2. TP gives stock to son who sells it today.1. After-tax cash flow for TP under Option 1? _______2. After-tax cash flow for Son under Option 2? _______

Change one fact. TP bought stock in 2010.1. After-tax cash flow for TP under Option 1? _______2. After-tax cash flow for Son under Option 2? _________

Loss SpreadingTP is in 40% income tax bracket and has substantial gains from stock sales. Son (an adult) is in 20% income tax bracket. TP owns ABC stock (purchased on 1-05-2012). ABC stock has FMV of $20,000 ABC stock has cost of $100,000

Option 1. TP sells ABC stock today (12-28-2012).Option 2. TP gives stock to son who sells it today.

1. After-tax cash flow for TP - Option 1? ____

2. After-tax cash flow for Son - Option 2? ____Should this stock be given to charity?

Sections1611001101210151221122212231(h)

Cash basis company is considering paying an expense in 2010 or 2011.

Amount of Expense $20,000Tax rate in 2010 45%Tax rate in 2011 50%Ignoring time value of money,how much is saved by waitinguntil 2011 to make the payment?

When to pay Expense - Slide 1

Expense $20,000 $20,000

Tax rate - 2010 45%

Tax rate - 2011 50%

Tax Savings $9,000 $10,000

When to pay Expense - Slide 2

Expense $20,000 $20,000

Tax rate - 2010 45%

Tax rate - 2011 50%

Tax Savings $9,000 $10,000

Discount at 12% 0.8930

Present value $8,930

What is your decision?

When to pay Expense - Slide 3

A single, wealthy investor earns net rental income of about $400,000 per year. She does not have significant itemized deductions. She is considering giving some rental property (that generates net rental income of $20,000 per year) to her elderly mother so that her mother will have income she needs for her living expenses. The investor expects that federal income taxes will be saved with this plan. Which tax planning concept applies here?

Monico Corp., a cash basis calendar-year taxpayer, is in the 25 percent marginal tax bracket this year. If it bills its customers at the beginning of December, it will receive $5,000 of income prior to year-end. If it bills its customers at the end of December, it will not receive the $5,000 until January of next year.

Monico Corp.a. If it expects its marginal tax rate to remain 25 percent next year, when should it bill its customers? Use a 6 percent discount factor to explain your answer. b. How would your answer change if Monico’s marginal tax rate next year is only 15 percent? Explain. c. How would your answer change if Monico’s marginal tax rate next year is 34 percent? Explain.

Monico Corporation. Solution: a. Monico should wait to bill its customers until the end of December. If Monico’s marginal tax rate is 25%, taxes paid this year would cost $1,250 ($5,000 x 25%) resulting in an after-tax cash inflow of $3,750 ($5,000 – $1,250). When considering the time value of money, the cost of the taxes that are deferred until next year will have a present value (cost) of only $1,179 ($1,250 x .943 PV factor) or $71 less ($1,250 - $1,179).

a. bill customers late, receivepayment next yearRevenue $5,000Tax rate 25%Tax payment next year 1,250After tax cash flow 3,750Tax payment next year 1,250Present value factor 0.943 P.V. of tax payment $1,179Amount of reduction $71.25

Monico Corp.

Monico Corp. Solution: b. If Monico’s marginal tax rate is 15% in year 2, then its after-tax cash inflow would be $4,293 [$5,000 – ($5,000 x 15% x .943 PV factor)]. Monico should defer billing its customers because this will result in a $543 higher after-tax cash inflow ($4,293 - $3,750).

Yr. 1 Yr 2Revenue $5,000 $5,000Tax rate 25% 15%Tax payment next year 1,250 750After tax cash flow 3,750 4,250Tax payment next year 1,250 750Present value factor 0.943 P.V. of tax payment $707Amount of reduction $42.75After tax cash flow 3,750 4,250After tax Present value $3,750 $4,293Difference $543Assumes revenue has 100% PV

Monico Corp. (B)

Monico Corp. Solution: c. If Monico’s marginal tax rate is 34% in year 2, then its after-tax cash inflow would be $3,397 [$5,000 – ($5,000 x 34% x .943 PV factor)]. Monico should bill its customers in the beginning of December because deferral would result in a $353 after-tax cost ($3,397 - $3,750).

In 2012, Ed's business had:Revenue $90,000Lease expense-truck & bldg. 10,000 Gas & other truck expense 6,000 Repair parts 4,000 Salary to Ed None1. Compute the corporate income tax.2. How does this affect Ed’s Form 1040? 3. What if he takes salary of $50,000?

(First, ignore FICA, then consider it.)4. What if he also takes $10,000 dividend?Note: Ed is single, no dependent, takes Std. Ded.

Ed's Repair Corporation. 1 of 6.

FactsRevenue $90,000Lease expense 10,000 Gas & other exp. 6,000 Repair parts 4,000 Salary to Ed NoneTotal ExpensesTaxable Income

Corporate Tax Amount Rate

First Layer 50,000 15%Next LayerCorporate Tax

Corporate Return

Ed's Repair Corp. 2 of 6.

FactsRevenue $90,000 $90,000Lease expense 10,000 10,000 Gas & other exp. 6,000 6,000 Repair parts 4,000 4,000 Salary to Ed NoneTotal Expenses 20,000 Taxable Income 70,000

Corporate Tax Amount Rate

First Layer 50,000 15% 7,500$ Next Layer 20,000 25% 5,000 Corporate Tax 12,500$

Corporate Return

Ed's Repair Corp. 3 of 6.

FactsRevenue $90,000Lease expense 10,000 Gas & other exp. 6,000 Repair parts 4,000 Salary to Ed 50,000 Total ExpensesTaxable Income

Corporate Tax Amount Rate

First Layer 15%Next Layer 25%Corporate Tax

Corporate Return

Ed's Repair Corporation. 4 of 6.

FactsRevenue $90,000 $90,000Lease expense 10,000 10,000 Gas & other exp. 6,000 6,000 Repair parts 4,000 4,000 Salary to Ed 50,000 50,000 Total Expenses 70,000 Taxable Income 20,000

Corporate Tax Amount Rate

First Layer 20,000 15% 3,000$ Next Layer - 25% - Corporate Tax 3,000$

Corporate Return

Ed's Repair Corporation. 5 of 6.

Ed elects S status for the corp.1. Compute the corporate income tax.2. What is impact on Ed’s Form 1040? 3. What if he takes salary of $50,000?

(First, ignore FICA, then consider it.)4. What if he also takes $10,000 dividend?Note: Ed is single, no dependent, takes Std. Ded.

Ed operates as a proprietorship1. What is impact on income reported

on Ed’s Form 1040? 2. Does Ed owe self-employment tax?

Ed's Corp or Proprietorship. 6 of 6.

End