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Exam 3: Tax Planning Strategies and Related Limitations

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Question 41

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The timing strategy becomes more attractive as tax rates decrease.

A) True
B) False

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Question 42

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If tax rates will be higher next year, taxpayers should defer their income to next year regardless of their after-tax rate of return.

A) True
B) False

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Question 43

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Sal, a calendar year taxpayer, uses the cash-basis method of accounting for his sole proprietorship. In late December he performed $40,000 of consulting services for a client. Sal typically requires his clients to pay his bills immediately upon receipt. Assume that Sal's marginal tax rate is 30% this year and 35% next year and that he can earn an after-tax rate of return of 12% on his investments. Should Sal send his client the bill in December or January? Use Exhibit 3.1. (Round discount factor(s) to 3 decimal places.)

If tax rates will be higher next year, taxpayers should accelerate their deductions regardless of their after-tax rate of return.

Lucky owns a maid service that cleans several local businesses nightly. Lucky, a high-tax rate taxpayer, would like to shift some income to his son Rocco. Lucky tells all of his customers (who are always timely in their payments) to pay Rocco and then Rocco will report 50% of the income as a collection fee. Lucky will report the remaining 50%. Will this shift the income from Lucky to Rocco? Why or why not? What doctrines influence your answer? Any suggestions for Lucky?

If Lucy earns a 6% after-tax rate of return, $8,000 received in four years is worth how much today? Use Exhibit 3.1. (Round present and future value amounts to 3 places)  

The time value of money suggests that $1 in one year from now is worth less than $1 today.

Joe Harry, a cash basis taxpayer, owes $20,000 in tax deductible accounting fees for his business. Assume that it is December 28ᵗʰ and that Joe Harry can avoid any finance charges if he pays the accounting fees by January 10ᵗʰ. Joe Harry's tax rate this year is 30%. His tax rate next year will be 33%. His after-tax rate of return is 8%. When should Joe Harry pay the $20,000 fees and why?  Use Exhibit 3.1. (Round discount factor(s) to 3 decimal places.)

In general, tax planners prefer to accelerate deductions.

The conversion strategy capitalizes on the fact that tax rates vary across different activities.

The timing strategy becomes more attractive if a taxpayer is able to accelerate deductions by two or more years (versus one year).

The timing strategy is particularly effective for cash basis taxpayers.

If Scott earns a 12% after-tax rate of return, $15,000 today would be worth how much to Scott in 2 years? Future value of $1. (Round present and future value factor(s) to 5 decimal places.)

Based only on the information provided for each scenario, determine whether Kristi or Cindy will benefit more from using the timing strategy and why there will be a benefit to that person. Use Exhibit 3.1.(Round discount factor(s) to 3 decimal places.) a. Kristi has a 40% tax rate and can defer $20,000 of income. Cindy has a 30% tax rate and can defer $30,000 of income. b. Kristy has a 30% tax rate, a 10% after-tax rate of return, and can defer $25,000 of income for three years. Cindy has a 40% tax rate, an 8% after-tax rate of return, and can defer $20,000 of income for four years.

Rodney, a cash basis taxpayer, owes $40,000 in tax deductible consulting fees for his business. Assume that it is December 28ᵗʰ and that Rodney can avoid any finance charges if he pays the accounting fees by January 10ᵗʰ. Rodney's tax rate this year is 30% and his after-tax rate of return is 10%. At what tax rate next year, will Rodney be indifferent between paying the $40,000 this year and next year? Use Exhibit 3.1. (Round discount factor(s) to 3 decimal places.)

Which of the following may limit the conversion strategy?

An astute tax student once summarized that many of the tax planning strategies merely make use of the variation of taxation across different dimensions. Explain why this is True. Be specific.

Explain why $1 today is not equal to $1 in the future. Why is understanding this concept particularly important for tax planning? What tax strategy exploits this concept?

Bono owns and operates a sole proprietorship and has a 30% marginal tax rate. He provides his son, Richie, $12,000 a year for college expenses. Richie works as a street musician and has a marginal tax rate of 15%. What could Bono do to reduce his family tax burden? How much pre-tax income does it currently take Bono to generate the $12,000 after-taxes given to Richie? If Richie worked for his father's sole proprietorship, what salary would Bono have to pay him to generate $12,000 after taxes? (Ignore any Social Security, Medicare, or Self Employment Tax issues.) How much money would this strategy save?

Rob is currently considering investing in municipal bonds that earn 4% interest or taxable bonds issued by Dell Computer that pay 6.5%. If Rob's tax rate is 20%, which bond should he choose? Which bond should he choose if his tax rate is 30%? At what tax rate would he be indifferent to the municipal bond or to the corporate bond? What strategy is this decision based upon?