Solution Manual for Taxes and Business Strategy, 5th Edition

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Solutions ManualTaxes and Business StrategyA Planning ApproachGlobal EditionFifth EditionMyron ScholesMark WolfsonMerle EricksonMichelle HanlonEd MaydewTerry Shevlin0

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CONTENTSChapter 1Introduction to Tax Strategy1Chapter 2Tax Law Fundamentals8Chapter 3Returns on Alternative Savings Vehicles18Chapter 4Choosing the Optimal Organizational Form30Chapter 5Implicit Taxes and Clienteles, Arbitrage, Restrictions and Frictions48Chapter 6Nontax Costs of Tax Planning67Chapter 7The Importance of Marginal Tax Rates and Dynamic Tax Planning Considerations82Chapter 8Compensation Planning93Chapter 9Pension and Retirement Program Planning107Chapter 10Multinational Tax Planning: Introduction and Investment Decisions121Chapter 11Multinational Tax Planning: Foreign Tax Credit Limitations and Income Shifting127Chapter 12Corporations: Formation, Operation, Capital Structure and Liquidation133Chapter 13Introduction to Tax Planning for Mergers, Acquisitions and Divestitures136Chapter 14Taxable Acquisitions of Freestanding C Corporations8139Chapter 15Taxable Acquisitions of S Corporations144Chapter 16Tax-Free Acquisitions of Freestanding C Corporations151Chapter 17Tax Planning for Divestitures162Chapter 18Estate and Gift Tax Planning1721

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Chapter 1Introduction to Tax StrategyDiscussion Questions1.a. This statement is correct since municipal bonds are tax-favored.b. This statement is not correct. For example, suppose (1) your tax rate is 30% and you can investin municipal bonds that yield 10% or equally risky taxable bonds that yield 16%. You should invest in thetaxables and pay explicit taxes of 4.8% to earn an after-tax return of 11.2% (which exceeds the 10% after-tax return on munis).c. This statement is correct when the business assets are eligible for favorable tax treatment toowners. This is the case in most countries. When owning is tax-favored, it gives rise to high implicittaxes. Low-tax-rate investors do not value the tax benefits as much as high-tax-rate investors do. The low-tax-rate investors can effectively sell the tax benefits to ownership by renting at reduced rental rates.d. This statement is not necessarily correct. Suppose that employers’ tax rates are going to fallmore than employee tax rates. In this case, the tax benefit of deferral to employees may be swamped bythe cost of deferral to the employer. By adjusting the level of current compensation, employees can bemade to prefer current payment. Nontax considerations may also be important. To the extent employeeshave a strong preference for current consumption and they cannot borrow funds at favorable interest rates,current compensation may be preferred even when taxes can be saved by deferring compensation. Wewill analyze this problem more formally in chapter Eight.2.After-tax rates of return are not always lower than pretax rates of return. For example, for a taxexempt municipal bond the after-tax rate of return equals the pretax rate of return. Consider also thefollowing counter-example. The taxpayer invests $1,000 in some activity with the investment beingimmediately tax deductible. At the end of the year the activity gives rise to a gain of $800 taxed as acapital gain. The taxpayer faces a tax rate of 39.6% on ordinary income and 20% on capital gains.The pre-tax rate of return in this simple example is (800 – 1,000)/1,000 = -20%.The after-tax rate of return is [800(1-.20) – 1,000(1-.396)]/1,000(1-.396) = (640 – 604)/604 =5.96%.3.a. Revenue less cost of goods sold from operations, dividend and interest income, royalties,rental income. Similarly to individuals, all items of income are included in gross income from whateversource unless specifically excluded by the Tax Code. Generally appreciation in the value of assets held isnot taxable until the gain is realized by sale or exchange of the asset.b. Tax exempt interest on municipal bonds.c. All expenses incurred in conducting the trade or business (§ 162). Depreciation of plant andbuildings, wages and salaries, interest expense, rental expense, advertising and marketing expenses,research and development expenditures, charitable contributions (within limits), deductions for past tax1

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Chapter 1Introduction to Tax Strategylosses (a net operating loss carryforward deduction), deduction for dividends received from othercorporations (the dividend received deduction) and utilities.d. Research and development credit, foreign tax credits, the alternative minimum tax credit.4.Tax avoidance is another label for effective tax planning. See the quote in the text attributed toJudge Learned Hand. The courts have upheld taxpayers’ rights to arrange their affairs in ways tomaximize their after-tax rates of return, provided the arrangements are within the law. Tax evasiondenotes activity that is outside the law such as not reporting income that is taxable, or falsely claiming oroverstating deductions. Tax evasion represents fraudulent activity and is illegal. Tax evasion is alsolabeled as deliberate noncompliance. A taxpayer facing a high marginal tax rate who buys a tax-exemptmunicipal bond and thus faces no explicit taxes is practicing tax avoidance but a taxpayer who buys ataxable corporate bond but omits the interest income on his tax return is practicing tax evasion.5.1.When facing a business decision in which taxes play a role, a planner employing efficienttax planning considers all of the costs, tax and nontax, that will be incurred by all of the parties to thetransaction. In addition to the explicit tax payments that will result from the transaction, the plannerconsiders implicit taxes that parties will pay in the form of lower before-tax rates of return on tax-favoredinvestments as well as any other non-tax costs associated with the transaction such as the costs ofrestructuring an organization to obtain favorable tax treatment. A planner whose criterion is taxminimization, on the other hand, ignores many of these costs. A tax minimizer considers only explicit taxcosts. It is easy to see that such a criterion may not result in desirable business strategies when oneconsiders that zero taxes are paid on unprofitable investments.6.Social planners should encourage taxpayers to engage in costly tax planning when no alternativemeans of attaining the same social goals is less costly. For example, consider the social goal of providinglow-income housing. A system of tax subsidies to providers of this housing may require some taxpayersto incur costs in considering the explicit taxes, implicit taxes, and nontax costs that would affect them andother parties if they were to build low-income housing. If the next-best alternative means of providinglow-income housing is for the government to build it directly, the social costs associated with providingthis housing may be higher.7.Greater specificity in the law can only be achieved at the higher cost of drafting and legislating.Moreover, where it is expensive for the taxing authority to monitor taxpayers' affairs closely (in otherwords, in the real world) specific rules can provide greater opportunities for taxpayers to structure theiraffairs in a way that exploits the rules. Greater specificity in the rules would also impose greater burdenson taxpayers and the taxing authority in learning what the relevant rules are. Once learned, however,greater specificity in the rules would give rise to fewer disputes between taxpayers and the tax collectorsregarding tax liabilities.8.a. Salary and wages, interest and dividend income, gains on sale of securities (may qualify forfavorable capital gains treatment). An individual’s income from operating a business is included in grossincome after deducting the cost of good sold. All items of income are included in gross income fromwhatever source unless specifically excluded by the Tax Code.2

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Chapter 1Introduction to Tax Strategyb. Municipal bond income is excluded from gross income (it is tax exempt).c. In calculating adjusted gross income, some items are deducted from gross income (calledDeductions for AGI). Examples include trade or business expenses such as advertising, depreciation, etcfor taxpayers operating a business. For employees, payments by the employer to reimburse the employeefor certain expenses such as travel, transportation and entertainment expenses incurred by the employeeare deductible. Moving expenses and losses from the sale or exchange of property are also classified asdeductions for AGI.Next the taxpayer deducts the maximum of itemized deductions or the standard deduction andexemptions to arrive at taxable income. Itemized deductions are expenses of a personal nature which theTax Code allows the taxpayer to deduct. Examples include home mortgage interest, property taxes, stateand local income taxes, charitable contributions, and medical expenses above a certain limit. The total ofitemized deductions is compared to the standard deduction (determined by the filing status of the taxpayer– single, married filing jointly, married filing separately, head of household, and surviving spouse)allowed by the Tax Code – the standard deduction is a fixed amount used to simplify the preparation ofthe tax return for taxpayers with relatively low itemized deductions. Finally each taxpayer is entitled to apersonal exemption (provided the taxpayer is not eligible to be claimed as a dependent on anothertaxpayer’s return).d. A credit is a dollar-for-dollar reduction in the taxpayer’s tax liability (and thus is worth morethan a deduction, because a deduction of $1 only reduces the tax liability by the taxpayer’s marginal taxrate). Examples of tax credits for individuals are the earned income credit, child tax credit, credit forelderly, dependent care credit, general business credit, and foreign tax credit (for individuals with foreignearnings and foreign taxes paid).(The reader interested in a more technical discussion is referred to any technical tax textbook.)3

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Chapter 1Introduction to Tax Strategy9.Shifting income is beneficial when a high-tax-rate taxpayer can shift before-tax income to a low-tax-rate taxpayer. One way this could be effected is for the low-tax-rate taxpayer to “sell” the right toreduced taxes to the high-tax-rate individual by setting the terms of trade accordingly. In the case ofrelated parties, the shifting income may be accomplishedwithout a quid pro quo.Shifting income can be costly in that it typically requires a distortion in asset ownership orcontrol; or it can give rise to distorted patterns of cash flows over time. For example, one way to shiftincome from high-income to low-income taxpayers is for high-income taxpayers to own tax-shelteredassets, like residential property, that are leased to low-income taxpayers. Another example is theformation of a partnership, where low-tax-rate taxpayers are allocated most of the annual income andhigh-tax-rate taxpayers are allocated most of the appreciation in the value of the partnership (to berealized on sale or liquidation of the partnership). In each example, the parties' incentives can be affectedin unfortunate ways.In family tax planning, one might transfer income-producing assets to a child with the intentionthat the earnings will pay for the child’s education. A risk, however, is that the child may drop out ofschool and spend the money foolishly. Another way to transfer income to a low-tax-rate family member isby employing them in a family business. To the extent the family member is ill-suited to the job, such astrategy exacts an efficiency cost.Under the assignment-of-income doctrine, taxpayers must transfer an income-producing asset to alow-tax-rate taxpayer in order to shift taxable income. Costs arise from the high-tax-rate individual notbeing able to control what the low-tax-rate individual does with the assets. One way to mitigate thesecosts is to transfer the assets to a trust and have the trustee manage the assets in a pre-specified manner.Exercises1.Alternative AAlternative BInvestment$20,000$18,000Expected Payoff$21,000 x .75 = $15,750$25,000 x .80 = $20,000Pretax rate of return(15,750-20,000)/20,000= -21.25%(20,000 – 18,000)/18,000= 11.11%After-tax rate of return*For taxpayer with 15% rate-7.35%11.11%For taxpayer with 35% rate21.15%11.11%*Alternative A: after-tax rate of return calculation:(expected payoff – after-tax cost of investment)/after-tax cost of investment4

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Chapter 1Introduction to Tax Strategy= (15,750 – 20,000[1-t])/20,000[1-t]. The expected payoffs represent tax savings which are tax-exempt.Alternative B: after-tax rate of return calculation:(expected after-tax payoff - after-tax cost of investment)/after-tax cost of investment= (20,000[1-t] – 18,000[1-t])/18,000[1-t] = 2,000[1-t]/18,000[1-t] = 2,000/18,000 = 11.11%.Since the payoff is ‘taxable’ (cost savings reduce the tax deduction) and the investment is taxdeductible at the same tax rate, the after-tax rate of return equals the pre-tax rate of return.The low-tax bracket taxpayer should invest in alternative B because this maximizes her after-taxrate of return. The high-tax bracket taxpayer should invest in alternative A. And note that alternative Arepresents tax planning activity and while the pretax rate of return is negative, for the high-tax brackettaxpayer, the after-tax rate of return is positive and higher than alternative B. This example illustrates thattax planning is a tax-favored activity which activity is more valuable for high-tax bracket taxpayers.2.Taxpayer A invests in corporate bonds: after-tax rate of return = .125(1-.28) = .09.Taxpayer B invests in tax-exempt municipal bonds: after-tax rate of return = .09.Thus both taxpayers are earning 9% per annum after-tax. Taxpayer B is not paying any explicittaxes but is paying implicit taxes in the form of a lower pre-tax rate of return compared to the 12.5%pretax rate of return on the fully taxable bond.a.The implicit taxes are being paid to the municipality issuing the tax-exempt bond.b.Taxpayer B is paying implicit taxes here at a rate of 28% (= [.125-.09]/.125).3.If receive bonus now: after-tax amount received is $30,000(1-.396) = $18,120. The taxpayer caninvest this amount to earn 5% after-tax for the year which will cumulate to $18,120(1.05) = $19,026 at theend of next year.If defer bonus for one year (assumed received at end of the next year, not at the start of the nextyear): after-tax amount received is $30,000(1-.31) = $20,700.Thus defer receipt of bonus for one year. However, if the taxpayer can earn 15% after-tax on herinvestment, then $30,000 received now will accumulate to $30,000(1-396)(1.15) = $20,838 which nowexceeds the amount from the one-year deferral.4.Price willing to pay for the corporate bond is $1,000 (the face value). The bond promises acoupon of 6% and the taxpayer requires a pretax rate of return of 6% as well. More formallyPrice = present value of the coupon payments + present value of the face amount(Pretax calculation): price = .06 x (1,000) x PVA + $1,000 x PV1where PVA is the present value of a $1 annuity for 5 years at 6% per annum = 4.212, andPV1 = is the present value of a dollar to be received in 5 years at 6% per annum = .747.Thus .06 x (1,000) x 4.212 + 1,000 x .747 = $1,000.(On an after-tax basis): price = [.06 x (1,000)](1-t) x PVA + $1,000 x PV1where the PVA and PV1 factors use an after-tax discount rate .06[1-.31] = .0414implying a PVA factor of 4.434 and PV1 of .8164. Thus,5

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Chapter 1Introduction to Tax StrategyPrice = [.06 x (1,000)](1-.31) x 4.434 + $1,000 x .8164 = $1,000.Price willing to pay for the municipal bond. Since the taxpayer can earn 4.14% after-tax byinvesting in the fully taxable bond, he requires this as a minimum rate of return on the muni and thus iswilling to pay a maximum ofPrice = .06 x (1,000) x PVA + $1,000 x PV1where PVA and PV1 are based on the after-tax discount rate of 4.14%. ThusPrice = .06 x (1,000) x 4.434 + $1,000 x .8164 = $1,082.44.The taxpayer is indifferent between the fully taxable bond at a price of $1,000 and the tax-exemptmunicipal bond at a price of $1,082.44 because at these prices both offer an after-tax rate of return of4.14%. This example relates to implicit taxes because the taxpayer is willing to pay more for the taxfavored treatment of the municipal bond thus lowering its pretax (also equal to after-tax) rate of return.The implicit tax is the difference between the 6% pretax return on the fully taxable bond and the 4.14%pretax rate of return on the muni. The implicit tax rate is 31% [(.06 - .0414)/.06].6

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Chapter 1Introduction to Tax StrategyTax Planning Problems1.If the CEOs’ actions or available projects from which she can choose are unobservable to thecompensation committee (a hidden information problem which is discussed in more detail in chapter 6,but which problem is common in large corporations) then the CEO has to be offered incentives to choosethose projects which maximizes the value of the firm (rather than maximizes the utility of the CEO). Onesolution is to tie part of the CEO’s compensation to the payoffs (either accounting earnings or stock price)– this is what bonuses as a function of reported earnings and employee stock options are intended to do.If the CEO is about to retire and is facing investment decisions that require large current outlayswith large future expected payoffs, the firm is said to face an horizon problem: the CEO is looking atshort-term results when the firm’s shareholders would rather a long-term focus. Again some sort ofcompensation package (say restricted stock or deferred bonus) that links compensation to the deferredoutcomes might be desirable.Oftentimes the CEO has much wealth (human capital and money) tied to the firm and is thuslikely to be more risk averse than shareholders who are likely to hold diversified portfolios. Thus riskaverse CEOs might forgo risky but positive net present value projects. Again the compensation packagemight include components (such as employee stock options that increase in value as the risk of the firmincreases) that encourage increased risk taking by the CEO.The firm in designing the compensation package thus must not only consider taxes but also whatincentives the compensation package might offer the CEO. Oftentimes, the CEO’s compensationpackage is designed with incentive alignment as the first priority and taxes as the second priority. Wewill discuss this issue in more detail in Chapter Six.2.First note that a firm with accumulated tax losses can carryforward these losses and deduct themagainst future taxable income. Traditionally, we think of firms with net operating loss carryforwards asfacing lower marginal tax rates than a firm currently earning income (discussed in more detail in ChapterSeven).Plan A: borrow and purchase the plant. Not very tax efficient because will not be deducting theinterest on the borrowing at high corporate tax rate nor will the depreciation deductions on the plant betaken at the highest tax rates.Plan B: issue equity and buy the plant. Issuing equity is tax efficient for low tax firms but buyingthe plant is not, for reasons given above.Plan C: leasing is likely the most tax efficient. Once we analyze the tax positions of both low tax-bracket and high tax-bracket taxpayers, we might find low tax-bracket taxpayers better off passing up taxsavings and renting. The reason is that low tax-bracket and high tax-bracket businesses will find itdesirable to enter into a contract that arranges property rights so that the low tax-bracket businesseseffectively sell their tax benefits to high tax-bracket businesses. This is accomplished by reducing the7

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Chapter 1Introduction to Tax Strategyrental rate to the low tax-bracket taxpayer in exchange for the right to take rapid depreciation, for taxpurposes, on the equipment.3.Implicit taxes arise because the before-tax investment returns available on tax-favored assets areless than those available on tax-disfavored assets. Taxpayers wishing to obtain the tax-favored treatmentoffered by the investment bid up the price of the investment lowering the pre-tax rate of return.Tax clienteles arise because of variation across taxpayers in tax rates. Certain taxpayers are morelikely than others to own various kinds of assets or to organize production in particular ways. Taxpayersfacing similar marginal tax rates are attracted to the same investments because they offer the highest after-tax rate of return to these taxpayers.A firm that relies on long-term debt for financing likely faces a high marginal tax rate because theinterest payments are tax deductible. Thus issuing debt to fund operations is tax efficient for high taxfirms. The owners of distribution facilities (and other buildings and equipment) can deduct the cost of theassets (called depreciation) in calculating taxable income. These tax deductions are most valuable to hightax bracket taxpayers. If the tax depreciation schedule exceeds the rate of economic depreciation then theasset can be labeled as tax-favored and buyers are likely to compete for the asset bidding up the price(leading to the asset bearing implicit taxes). High tax rate taxpayers are the efficient owners of thesetypes of assets. Leasing is often more efficient than buying for low tax bracket taxpayers. Thus if welook at the asset side, we might infer that ABC Corporation faces a low tax rate but when we look at thefunding side of the economic balance sheet we might infer that ABC Corporation is a high tax ratecorporation. Obviously both inferences cannot be right and thus it is likely that ABC Corporation is inthe wrong clientele on one side of the balance sheet: if it is a low tax firm it should not have long-termdebt outstanding. If it is a high-tax rate firm, it should not be leasing assets. (This solution focuses on thetax aspects of the problem – as we will learn in later chapters, there might be nontax reasons for thestructure of the firm’s balance sheet, for example, nontax reasons for leasing.)4.You would like to meet with the CEO so as to obtain information about the CEOs tax position,the rate at which the CEO can earn on her personal investments, and her preferences for currentconsumption (income) and current savings (deferred income). The CEO’s tax position depends not onlyon the salary from the firm but also any other income arising from her investments outside the firm. Byknowing the CEO’s tax position, as well as the firm’s tax position, you can design a more tax efficientcompensation package where efficiency includes the tax position of both parties.8

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Chapter 2Tax Law FundamentalsDiscussion Questions1.a. False. While some tax rules written by Congress are written in the form of very specificrestrictions that respond to particular abuses of the tax system that are experienced or anticipated, mosttax rules lack the specificity necessary to eliminate ambiguity in the law. Given the enormous range ofcircumstances in which taxpayers can find themselves, the costs for Congress to pass legislation that issufficiently comprehensive to cover all situations is greater than the benefits of greater clarity in the taxrules.b. False. Most tax legislation in the U.S. is initiated in the House. The Constitution (Article 1,Section 7, Clause 1) holds the House responsible for initiating revenue bills (although tax bills could beattached to other bills that originate in the Senate).c. True. Congress authorizes the Secretary of the Treasury to issue rules and regulations toenforce the Code. The primary purpose of the regulations is to explain and interpret particular sections ofthe Code. Regulations come in three types: (1) Legislative Regulations where Treasury has been givenspecific authority to issue a regulation pertaining to a particular section of the Code, (2) InterpretativeRegulations that explain the meaning of a particular Code section and commit the Treasury and IRS (butnot necessarily the courts) to a particular position, and (3) Procedural Regulations that explain issues suchas the information that taxpayers must provide to the IRS and how the IRS is to conduct its affairs. Whileregulations are considered a direct extension of the lawmaking powers of Congress, revenue rulings areconsidered an application of the (more limited) administrative power of the IRS and thus have lessauthority. IRS rulings are also more limited in scope in that they are based on a specific set of facts.d. True. Revenue Rulings are published as official IRS policy while private letter rulings applyonly to the taxpayer requesting the ruling and cannot be cited as precedent in a court of law. Still, privateletter rulings are often considered carefully by taxpayers as clues to IRS policy.e. False. While the courts do not issue regulations per se, court decisions are a source of tax lawand the IRS Commissioner is bound by legal precedents.2.Appreciation in the price of assets is not taxed until the asset is sold (and income realized). Whenwe apply this rule to investments in corporate stock, stock price appreciation is not taxed until the stock issold and the gain is realized. This tax treatment encourages investors to buy and hold stock incorporations thus providing equity funds to corporations for their investment needs. However, some largestockholders in an effort to defer the taxation of the gains while at the same time obtaining cash undertaketransactions known as “shorting against the box.” This strategy involves the taxpayer borrowing shares ofstock equal to the number already owned and then selling the borrowed shares. The taxpayer then sellsthe borrowed shares thus realizing cash but no taxes are owed because there was no taxable gain on theshares sold. The loan is repaid at a later date by delivering the original appreciated stock. Delivery of thestock also triggers tax on the gain at this later date. The taxpayer has to pay interest on the value of theshares borrowed. It can be argued that this transaction serves no other purpose than to obtain cash todaywhile deferring the taxes on the appreciated securities.9

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Chapter 2Tax Law FundamentalsThere are numerous other examples but serving no social purpose is a strict standard so one canthink of many transactions that are designed to exploit the tax rules that have limited social purposes.3.Basically see figure 2.1 and the accompanying text.4.Greater specificity in the law can only be achieved at the higher cost of drafting and legislating.Moreover, where it is expensive for the taxing authority to monitor taxpayers' affairs closely (in otherwords, in the real world) specific rules can provide greater opportunities for taxpayers to structure theiraffairs in a way that exploits the rules. Greater specificity in the rules would also impose greater burdenson taxpayers and the taxing authority in learning what the relevant rules are. Once learned, however,greater specificity in the rules would give rise to fewer disputes between taxpayers and the tax collectorsregarding tax liabilities.5.These judicial doctrines discourage taxpayers from structuring their transactions to minimizetaxes while not adhering to the social policy goals of the tax law. They allow the taxing authority toexamine a transaction to determine if it has any motivation other than tax avoidance. If not, tax-favoredtreatment is imperiled. Unfortunately, such doctrines may also discourage socially desirable activities dueto taxpayer concern over how the doctrine will be applied in practice. On the positive side, the doctrinesalso serve to discourage those transactions that are structured to appear, falsely, as contributing to thesocial goals that motivated the granting of tax-favored treatment to certain types of activities.6.The Tax Code has multiple objectives: to redistribute wealth in the economy, to raise revenue,and to encourage (or discourage) desired economic activities. These multiple objectives naturally giverise to tax rates varying across different economic activities, tax rates varying across different individualtaxpaying units, and tax rates varying for a given taxpaying unit over time. These differential tax rates, inturn, provide strong incentives for taxpayers to engage in tax planning. These incentives are the keyingredients that allow the tax system to be used to implement desired social policy.As an example, one economic activity that is encouraged is savings for retirement which issubsidized by the tax code in several ways (contributions are tax deductible and earnings in the pensionfund are tax deferred until withdrawn in retirement). The wealthy are best placed to take advantage ofthese incentives. However the objective of redistributing wealth and raising revenue results in Congressplacing limits on the deductibility of pension contributions both by amount and with phase outs based onadjusted gross income and filing status.Basically, Congress balances incentives against lost tax revenue and wealth redistribution givingrise to complexity in the code. As incentives are offered, taxpayers aggressively exploit the incentives toavoid taxes and as the tax revenue lost grows, Congress then introduces additional rules to “plug” theloopholes.Another cause of complexity is that the tax code allows legislators to allocate benefits in returnfor votes. Specific provisions are included for targeted groups of taxpayers.Both these causes of complexity (multiple objectives and vote gathering) are unlikely to becorrectable. It is unlikely that Congress will forgo using the Tax Code to achieve multiple objectives andto forgo vote gathering via the code.10

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Chapter 2Tax Law Fundamentals7.Related parties whose interests do not conflict can afford (more than unrelated parties can) toenter into agreements that avoid stating explicitly in a contract the full nature of their transactions. Partieswith opposing interests, who rely upon the law to enforce their claims, find such arrangements to berelatively unreliable. Tax laws discriminate against related-party contracts because it is easier for theparties to such contracts to engage in sham transactions designed to avoid taxes than is the case for partiescontracting at arm’s length.Discriminating against related parties is not always in society’s best interests. The costsassociated with enforcing and writing arm’s-length contracts can be significantly greater than thoseinvolving related parties. For example, a family business might be more efficient than a partnership orcorporation comprised of unrelated parties because the mutual trust among family members can substitutefor the detailed contracts that would have to be written, and the monitoring that would have to beundertaken, to ensure comparable outcomes.8.Shifting income is beneficial when a high-tax-rate taxpayer can shift before-tax income to a low-tax-rate taxpayer. One way this could be effected is for the low-tax-rate taxpayer to “sell” the right toreduced taxes to the high-tax-rate individual by setting the terms of trade accordingly. In the case ofrelated parties, the shifting income may be accomplishedwithout a quid pro quo.Shifting income can be costly in that it typically requires a distortion in asset ownership orcontrol; or it can give rise to distorted patterns of cash flows over time. For example, one way to shiftincome from high-income to low-income taxpayers is for high-income taxpayers to own tax-shelteredassets, like residential property, that are leased to low-income taxpayers. Another example is theformation of a partnership, where low-tax-rate taxpayers are allocated most of the annual income andhigh-tax-rate taxpayers are allocated most of the appreciation in the value of the partnership (to berealized on sale or liquidation of the partnership). In each example, the parties' incentives can be affectedin unfortunate ways.In family tax planning, one might transfer income-producing assets to a child with the intentionthat the earnings will pay for the child’s education. A risk, however, is that the child may drop out ofschool and spend the money foolishly. Another way to transfer income to a low-tax-rate family member isby employing them in a family business. To the extent the family member is ill-suited to the job, such astrategy exacts an efficiency cost.Under the assignment-of-income doctrine, taxpayers must transfer an income-producing asset to alow-tax-rate taxpayer in order to shift taxable income. Costs arise from the high-tax-rate individual notbeing able to control what the low-tax-rate individual does with the assets. One way to mitigate thesecosts is to transfer the assets to a trust and have the trustee manage the assets in a pre-specified manner.9.A national sales tax system would not eliminate all incentives to shift economic activities in waysthat reduce taxes. Taxpayers would still have incentives to shift activities across periods to secure low-income household benefits as well as to exploit changes in sales tax rates across periods. Taxpayerswould still have incentives to repackage goods into those that are granted tax exemption (shifting fromone type of activity to another). And taxpayers would still have incentives to have consumption shiftedfrom high-income to low-income “pockets” to secure reduced tax rates. The substance-over-form andbusiness purpose doctrines would remain as important as ever in enforcing the tax law.11

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Chapter 2Tax Law Fundamentals10.Revenue rulings reduce taxpayer uncertainty regarding the tax treatment of particulartransactions. Withholding such rulings can discourage taxpayers from entering into transactions that aregranted tax-favored treatment. If the taxing authority wishes to maximize tax collections, withholdingrevenue rulings may be in its best interest even if it were costless to supply the rulings. Whether this isdesirable, however, also depends on the social costs and benefits of the transactions that are discouraged.An additional cost of revenue rulings, of course, is the personnel cost required to do the researchneeded to provide the ruling. On the benefit side, revenue rulings can enhance the tax authority's abilityto enforce the law by warning it of the types of transactions that taxpayers are contemplating enteringinto. Where the overall social costs to responding to ruling requests exceed the social benefits, charging afee to the requesting taxpayer can align social and private costs and benefits better than a system inwhich there is no charge for such requests.11.To the extent possible defer recognition of much income as possible until next year and accelerateas many deductions as possible to the current period. Deferral of income options: delay payment andreceipt of any bonuses until the following tax year (the tax efficiency of this strategy depends on what ishappening to the employer’s tax rate – if it is also expected to fall, then a careful analysis has to beundertaken – an example of multilateral tax planning.) Do not sell any appreciated assets or securitiesthat give rise to taxable gains until next year. Shift stock portfolio from dividend paying stocks to non-dividend paying stocks to defer income until next period. The taxpayer has to be careful not to run afoulof the constructive receipts doctrine. This doctrine basically prevents taxpayers from turning their backson income they have already earned and could collect easily. Examples include (1) interest credited onbank accounts where funds are available for withdrawal at any time, and (2) year-end paychecks that canbe picked up at the payroll department. The Internal Revenue Service (IRS) has the authority to adjust ataxpayer’s method of accounting to ensure that it “clearly reflects income.” Most abuses of accountingmethods involve postponing taxable income.Acceleration of deductions include making an extra mortgage payment at the end of the yearqualifying the interest to be deductible in the current period, accelerating any elective medical procedures(provided the sum of the expenditures exceed the lower limit before they become deductible), andincreasing to the extent possible any tax deductible personal pension contributions.12.A flat tax system would not eliminate all incentives to shift economic activities in ways thatreduce taxes. Taxpayers would still have incentives to shift activities across periods to defer taxation aswell as to exploit changes in tax rates across periods. Taxpayers would still have incentives to restructureactivities/transactions into those that are granted tax exemption (shifting from one type of activity toanother, small businesses using lots of owner supplied debt – interest deductible to the firm but nottaxable to the recipient). And taxpayers would still have incentives to shift income from high-income tolow-income “pockets” (those family members with low income such that the high standard exemptionreduces their tax bill to zero) to secure reduced tax rates. The substance-over-form and business purposedoctrines would remain as important as ever in enforcing the tax law. (The interested reader is referred to12

Solution Manual for Taxes and Business Strategy, 5th Edition - Page 16 preview image

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Chapter 2Tax Law Fundamentalsan excellent in-depth analysis of tax planning under a flat tax by Michael Calegari, “Flat Taxes andEffective Tax Planning,” in National Tax Journal, December 1998, pp. 689-713.)And finally given the multiple objectives that Congress uses the Tax Code to pursue (toredistribute wealth in the economy, to raise revenue, and to encourage (or discourage) desired economicactivities, as well as being use by individual legislators and the two major political parties to garnerpolitical support) we do not believe a flat tax with no itemized deductions is politically feasible in theU.S.Exercises1.a. Pretax rate of return, R, = ($50,000-$100,000)/$100,000 = -50%.b. After-tax rate of return, r, =)70.1(000,100$)28.1(000,50$−−- 1 = 20%.(Explain your answer. Do you see any tax planning opportunities?)2.a. If receive now and invest after-tax proceeds, the taxpayer will accumulate by the end of nextperiod$100,000(1-t)(1+R(1-t))= $100,000(1-.31)(1+.10(1-.31))= $73,761.If defer receipt then after-tax will have$110,000(1-t) = $75,900.Thus defer receipt for one year.b. Equate the two alternatives and solve for R$100,000(1-t)(1+R(1-t)) = $110,000(1-t)1+R(1-t) = 110,000/100,000 = 1.10R = .10/(1-t) = .10/.69 = .1449 or 14.49%.(check by inserting R = .1449 in a).c. If receive now and invest after-tax proceeds, the taxpayer will accumulate by the end of nextperiod$100,000(1-t1)(1+R(1-t2))= $100,000(1-.31)(1+.10(1-.35))= $73,485.If defer receipt then after-tax will have$110,000(1-t2) = $110,000(1-.35) = $71,500.Thus take now, do not defer.d. Equate the 2 alternatives and solve for t2$100,000(1-.31)(1+R(1-t2)) = $110,000(1-t2),$69,000(1+.10(1-t2)) = $110,000(1-t2),13

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