Tax Planning Fundamentals PDF

i. A partnership is not a separate taxable entity. ii. The partnership files a tax return (Form 1065) on which it summarizes the financial results of the business. Each partner then reports his or her share of the net income or loss and other special items that were reported on the partnership retur...

i. A partnership is not a separate taxable entity. ii. The partnership files a tax return (Form 1065) on which it summarizes the financial results of the business. Each partner then reports his or her share of the net income or loss and other special items that were reported on the partnership return. (See Chapter 14 in the text.) d. S Corporations i. Corporations that meet certain requirements and pay no Federal income tax at the corporate level are referred to as S corporations, because they are governed by Subchapter S of the Code. (See Chapter 15 in the text.) ii. An S corporation is treated like a C corporation for all nontax purposes as both are entities formed under a particular state's corporate law. Regarding tax factors, however, an S corporation is more like a partnership. e. Limited Liability Companies and Limited Liability Partnerships i. Limited liability companies (LLCs) and limited liability partnerships (LLPs) offer limited liability and some (but not all) of the other nontax features of corporations. ii. Both forms usually are treated as partnerships for tax purposes. iii. The S corporation, limited liability company, and partnership forms of f. organization, which are referred to as flow-through entities, avoid the double taxation problem associated with the C corporation. Dealings between Individuals and Their Business Entities i. The following are some of the major interactions between owners and business entities: 1. Owners put assets into a business when they create a business entity (e.g., a proprietorship, partnership, or corporation). 2. Owners take assets out of the business during its existence in the form of salary, dividends, withdrawals, redemptions of stock, etc. 3. Through their entities, owner-employees setup retirement plans for themselves, including IRAs and qualified retirement and pension plans. 4. Owners dispose of all or part of a business entity. ii. The following are a few of the many tax issues that arise: 1. How the tax law applies at.both the owner level and the entity level (i.e., the multiple taxation problem) and what effective tax rate is assessed on such income. 2. How to move assets into the business with the least adverse tax consequences. 3. How to pull assets and accumulated profits out of the business with the least adverse tax consequences. 4. How to dispose of the business entity with the least adverse tax consequences. 5. Whether certain tax rules will apply less favorably because the business and owner(s) are related parties. V. Tax Planning Fundamentals (1.6, PPT Slides 64-70) a. Overview of Tax Planning and Ethics i. It is a long-standing principle that taxpayers have no obligation to pay more than their fair share of taxes. ii. Tax Planning: Avoidance Versus Evasion. 1. Minimizing taxes legally is referred to as tax avoidance. 2. Tax evasion is attempting to evade income taxes through illegal actions. 3. Clients expect tax professionals to provide advice to help them minimize their tax costs through tax planning. iii. The Ethics of Tax Planning. Tax planning (avoidance) is a fully ethical activity by the taxpayer and the tax professional, but tax evasion (fraud) is not. 1. The tax adviser's actions are limited by the codes of conduct of various professional organizations. 2. Other formal restrictions and directives concerning the conduct of the tax professional can be found in two broad forms. Penalties and interest may apply to the taxpayer when a tax liability is understated. (b) Sanctions are used for tax preparers who disregard the tax law. Tax penalties also apply when the tax preparer fails to sign a tax return that he or she has worked on or takes an improper filing position on a tax return. b. A General Framework for Income Tax Planning i. The primary goal of tax planning is to design a transaction so as to minimize its tax costs while meeting the other nontax objectives of the client. ii. Careful analysis of the tax formula (refer to Exhibit 1.1 in the text) reveals a series of tax minimization strategies. iii. The General Framework for Income Tax Planning in Exhibit 1.3 in the text lists each element in the income tax formula, develops tax planning strategies designed to minimize taxes, and provides brief summaries of specific examples of tax planning. iv. In addition to a planning framework focused on the tax formula, another planning framework is focused on four questions: when?/what?/who?/where? 1. When: How do tax accounting method rules affect when income and deductions are reported? See text Sections 4-3 and 5-2. (a) 2. What: What exclusions, deductions and tax credits can be applied to reduce taxable income and tax liability? See Chapters 4, 5, 10, and 17 in the text. 3. Who: Which party to a transaction will report inco_me? See text Section 9-5e and Chapters 12 through 15 in the text. 4. Where: In which state or states (or foreign country) can the income be generated or taxed? See Chapter 16 in the text. c. Tax Minimization Strategies Related to Income i. Avoid income recognition. (See Example 19 in the text.) ii. Postpone recognition of income to achieve tax deferral. (See Example 20 in the text.) d. Tax Minimization Strategies Related to Deductions i. Maximize deductible amounts. A corporation that owns stock in another corporation is eligible for a dividends received deduction (ORD). 1. The ORD is equal to a specified percentage of the dividends received. The percentage is based on the amount of stock that the investor corporation owns in the investee corporation. • 50% deduction for ownership of less than 20%. • 65% deduction for ownership of 20% or more but less than 80%. • 100% deduction for ownership of 80% or more. 2. Example 21 in the text demonstrates the tax advantage of dividend income versus interest income. ii. Accelerate recognition of deductions to achieve tax deferral. (See Example 22 in the text.) e. Tax Minimization Strategies Related to Tax Rates i. Shift net income from high-bracket years to low-bracket years. (See Examples 23 and 24 in the text.) ii. Shift net income from high-bracket taxpayers to low-bracket taxpayers. (See Example 25 in the text.) iii. Shift net income from high-tax jurisdictions to low-tax jurisdictions. (See Examples 26 and 27 in the text.) iv. Control the character of income and deductions. (See Example 28 in the text.) v. Avoid double taxation. 1. Shareholders can avoid double taxation by electing that a corporate entity become an S corporation. (See Example 29 in the text.) 2. Other entity choices can be used to avoid double taxation, including partnerships and limited·liability companies. 3. Choosing to operate as a flow-through entity is not the only way to avoid double taxation. Double taxation can be avoided or minimized by having the corporation make tax-deductible payments, such as salaries, rent, and interest to the shareholders. (See Example 30 in the text.) f. VI. Tax Minimization Strategies Related to Tax Credits i. Maximize tax credits. (See Example 31 in the text;) 1. A deduction reduces taxable income, which results in a reduction of the tax paid. 2. A tax credit reduces the tax liability dollar for dollar and is not affected by the taxpayer's tax rate. Understanding the Federal Tax Law (1.7, PPT Slides 71-73) i. The Federal tax law reflects the three branches of our Federal government. It is a mixture of laws passed by Congress, explanations provided by the Treasury Department and the Internal Revenue Service (IRS), and court decisions. a. Revenue Needs i. In an ideal world, taxes raised by the government would equal the expenses incurred by government operations. ii. The U.S. Constitution allows deficit spending, and politicians often find it hard to resist the temptation to spend more than the tax system collects currently. b. Economic Considerations i. Sometimes tax legislation is designed to help control the economy in some manner or encourage certain activities, industries, or businesses. ii. Encouragement of Certain Activities. Congress often uses the tax law to encourage certain types of economic activity or segments of the economy. 1. To encourage investment in certain business assets, such as equipment, the tax law may allow for extra ("bonus") depreciation in the year of acquisition. 2. Ecological considerations justify a tax provision that permits a more rapid expensing of the costs of installing pollution control facilities or tax credits for the use of alternative energy. 3. Considering the pressing and continuing problem of a deficit in the U.S. balance of payments, Congress has established incentives for U.S. citizens who accept employment overseas and for business entities that operate in countries outside the United States. 4. Saving can lead to capital formation, making funds available to finance home construction and industrial expansion. The tax law encourages saving by according preferential treatment to private retirement plans. iii. Encouragement of Certain Industries. 1. Historically, agricultural activities have been favored under Federal tax law. Among the tax benefits are the election to expense rather than capitalize certain soil and water conservation expenditures and fertilizers and the election to defer the recognition of gain on the receipt of crop insurance proceeds. 2. To stimulate the research and production of alternative fuel sources, tax incentives are allowed with respect to operations and sales of certain solar and wind energy devices and of autos that do not consume petroleum products. iv. Encouragement of Small Business. The belief that what is good for small business is good for the economy as a whole has led to special provisions in the tax law that favor small business. c. Social Considerations i. Some provisions of the Federal tax law, particularly those dealing with individuals, can be explained by a desire to encourage certain social results. 1. Certain benefits provided to employees through accident and health insurance plans financed by employers are nontaxable to employees. 2. A contribution made by an employer to a qualified pension or profit sharing plan for an employee may receive special treatment. 3. A deduction is allowed for contributions to qualified charities. 4. Various tax incentives are designed to encourage taxpayers to obtain or extend their level of education. 5. A tax credit is allowed for amounts spent to furnish care for certain minor or disabled dependents to enable the taxpayer to seek or maintain gainful employment. 6. A tax deduction is denied for certain expenditures deemed to be contrary to public policy (e.g., fines, penalties, illegal kickbacks, bribesto government officials, and gambling losses in excess of gains). d. Equity Considerations i. The concept of equity (or fairness) is relative. Lawmakers and others often consider whether a tax change is progressive or regressive to understand its impact on taxpayers and whether the change should be made. ii. If a tax represents the same percentage of the income of all taxpayers, it is a proportional tax. iii. The Wherewithal to Pay Concept. The wherewithal to pay concept recognizes the inequity of taxing a transaction when the taxpayer lacks the means to pay the tax. 1. This concept underlies a provision in the tax law dealing with the treatment of gain resulting from an involuntary conversion-which occurs when property is destroyed by casualty or taken by a public authority through condemnation.