Federal Taxation MBA 622

1
Federal TaxationMBA 622

• Chapter 4
• Maxims of Income Tax Planning
• and Income Exclusions

2
Lets Begin With Exclusions

• This chapter will include two main areas
• First, a review of income exclusions
• Second, a review of important maxims of income
  tax planning

3
A Review of Exclusions

• Last chapter we reviewed income inclusions
• In this chapter, we will review the statutory
  items that a taxpayer is allowed not to report as
  gross income!

4
Typical Exclusions

• Exclusions are the statutory exceptions to the
  definition of income as broadly defined.
• Congress felt that the following items should not
  be included in income!

5
Typical Exclusions

• 1. Inheritances
• 2. Gifts
• 3. Life insurance proceeds paid by reason of
  death
• 4. Employee death benefits
• 5. Scholarships

6
Typical Exclusions

• 6. Damage awards
• 7. Workmens compensation benefits
• 8. Accident and health insurance benefits
• 9. Medical reimbursement plan payments to
  employees

7
Typical Exclusions

• 10. Meals and lodging provided by employer
• 11. Other employee fringe benefits that may be
  excluded - many items including
• 12. Foreign earned income exclusion
• 13. State, local, and muni bond interest income

8
Typical Exclusions

• 14. Stock dividends
• 15. Child Support
• 16. Educational savings bond interest
• 17. Roth IRA distributions
• 18. Gain from the sale of a personal residence to
  limits of 250/500k every two years

9
Jones - Chapter 4Key Concepts and Terms

• Review the following portions of Chapter 4 in the
  Jones text
• Basic maxims of tax planning
• Emphasize the concepts on the following slides!

10
Income Tax Planning

• Considerations
• 1. The Entity
• 2. The Time Period
• 3. The Jurisdiction
• 4. The Character of Income

11
Income Tax Planning

• 1. The Entity
• Provisions in the Internal Revenue Code governing
  the computation of taxable business income apply
  uniformly across organizational forms. Thus, the
  amount of taxable income does not depend on the
  business entity selected. However, the amount of
  tax paid depends on the difference in tax rates
  across entities. The two primary tax paying
  entities are corporations and individuals.

12
Income Tax Planning

• 1. The Entity
• Individual taxpayers
• have a progressive tax rate structure that ranges
  from 15 percent to 39.6 percent
• Corporate taxpayers
• have a progressive tax rate structure that ranges
  from 15 percent to 35 percent

13
Income Tax Planning

• 1. The Entity
• Thus, entity choice can be very important for new
  ventures because tax rates paid by corporations
  and individuals can be dramatically different.
  Tax costs decrease (and cash flows increase) when
  income is generated by an entity subject to a low
  tax rate.
• What about established business entities?
• Reducing tax liabilities may depend on
• Income Shifting --Deduction Shifting

14
Income Tax Planning

• 1. The Entity
• Income Shifting
• Arranging transactions for the purpose of
  transferring income from a high tax rate entity
  to a low tax rate entity.
• Deduction Shifting
• Arranging transactions for the purpose of
  transferring deductions from a low tax rate
  entity to a high tax rate entity.
• The IRS and Congress are aware of taxpayer
  attempts to accomplish either of these shifting
  activities. Thus, taxpayers must be careful to
  arrange transactions that represent legitimate
  tax avoidance instead of tax evasion. A powerful
  doctrine developed from several court cases that
  limits income shifting is the Assignment of
  Income Doctrine

15
Income Tax Planning

• 2. The Time Variable
• Because federal and state taxing authorities
  impose a tax on income only once a year, the tax
  paid or tax savings from any transaction depends
  on the year the transaction occurs. Thus, the
  following maxim is applicable
• In present value terms, tax costs decrease (and
  cash flows increase) when a tax liability is
  deferred until a later taxable year.
• However two factors may limit the applicability
  of this maxim
• Opportunity Costs
• Tax Rate Changes

16
Income Tax Planning

• 2. The Time Variable
• Opportunity Costs
• Shifting tax liabilities to a later period also
  may entail shifting income to a later period.
  Thus, the opportunity costs of shifting the
  income may be greater than the tax savings
  associated with the liability deferral.
• Tax Rate Changes
• Deferring tax liabilities to later periods is
  only beneficial if the entitys tax rate remains
  constant or declines. If taxpayers defer a tax
  liability to a future date and Congress increases
  tax rates the benefits of the deferral may be
  lost or substantially limited.

17
Income Tax Planning

• 3. The Jurisdiction Variable
• The Jurisdiction variable has become increasingly
  important because, even though federal tax laws
  apply to all locations in the U.S., most states
  and the District of Columbia also impose a tax on
  business income.
• Thus, the aggregate tax liability of a firm is a
  function of the structural differences in state
  tax systems. This leads to the third maxim
• Tax Costs decrease (and cash flows increase) when
  income is generated in a jurisdiction with a low
  tax rate.

18
Income Tax Planning

• 3. The Jurisdiction Variable
• Businesses are buying and accounting firms are
  selling more advice on dealing with the
  complexity of operating in multiple states than
  ever before.
• Managers must be aware that they can often
  minimize the tax burden of the firm by conducting
  their activities in jurisdictions with favorable
  tax climates.

19
Income Tax Planning

• 4. The Character of Income
• The character of income refers to whether income
  is classified as ordinary or capital.
• Ordinary income is generated by the routine
  operations of a business or investment activity.
  This includes service income, sales, interest,
  dividends, royalties, and rents. Ordinary
  income is subject to tax at regular tax rates.
• Capital income is generated by the sale of assets
  which are not excluded from being capital assets.
  Capital income has consistently been subject to
  lower tax rates than ordinary income.

20
Income Tax Planning

• 4. The Character of Income
• The existence of these two income types leads to
  the following applicable maxim
• Tax costs decrease (and cash flows increase) when
  income is taxed at a preferential rate because of
  its character.
• It is also the case that because one form of
  income receives preferential tax rates, taxpayers
  are continually trying to arrange transactions
  such that ordinary income is converted to capital
  income. However the Tax Code contains dozens of
  provisions that prohibit the artificial
  conversion of ordinary to capital income.

21
Income Tax Planning

• Summary
• Tax planning strategies that reduce tax costs and
  increase cash flows typically reflect at least
  one of the maxims provided. In some cases, a
  strategy may follow one maxim but violate one or
  more of the others. In this case, the business
  manager must carefully assess the overall tax
  consequences of such a strategy.

22
Final Thoughts

• When I go fishing, I go mainly for the
• Halibut ----gtgtgt
• Old fishermen never die, they just smell that
  way. - Confucius
• Q1,3,4,5,6,13,14
• AP3,4,10,11