Question & Answer

Assume Ellina earns a 10 percent after-tax rate of return and that she owes a friend $1,200. Would she prefer to pay the friend $1,200 today or $1,750 in four years?

Assume Rafael can earn an 8 percent after-tax rate of return. Would he prefer $1,000 today or $1,500 in five years? 

Geraldo recently won a lottery and chose to receive $100,000 today instead of an equivalent amount in 10 years, computed using an 8 percent rate of return. Today, he learned that interest rates are expected to increase in the future. Is this good news for Geraldo given his decision?

Using the facts from the previous problem, when should Hank send the bill if he expects his marginal tax rate to be 35 percent next year? 24 percent next year?

} Hank, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December, he performed $20,000 of legal services for a client. Hank typically requires his clients to pay his bills immediately upon receipt. Assume his marginal tax rate is 32 percent this year and will be 37 percent next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Hank send his client the bill in December or January? 

Using the facts from the previous problem, when should Reese pay the bill if she expects her marginal tax rate to be 35 percent next year? 24 percent next year?

Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December, she received a $20,000 bill from her accountant for consulting services related to her small business. Reese can pay the $20,000 bill any time before January 30 of next year without penalty. Assume Reese’s marginal tax rate is 32 percent this year and will be 37 percent next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

Using the facts from the previous problem, how would your answer change if Manny’s after-tax rate of return were 8 percent?

Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $20,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Manny’s marginal tax rate is 37 percent this year and next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Manny send his client the bill in December or January?

Using the facts from the previous problem, how would your answer change if Isabel’s after-tax rate of return were 8 percent?

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next? 

Tesha works for a company that pays a year-end bonus in January of each year (instead of December of the preceding year) to allow employees to defer the bonus income. Assume Congress recently passed tax legislation that decreases individual tax rates as of next year. Does this increase or decrease the benefits of the bonus deferral this year? What if Congress passed legislation that increased tax rates next year? Should Tesha ask the company to change its policy this year? What additional information do you need to answer this question?

Billups, a physician and cash-method taxpayer, is new to the concept of tax planning and recently learned of the timing strategy. To implement the timing strategy, Billups plans to establish a new policy that allows all his clients to wait two years to pay their co-pays. Assume that Billups does not expect his marginal tax rates to change. What is wrong with his strategy?

Yong recently paid his accountant $10,000 for elaborate tax planning strategies that exploit the timing strategy. Assuming this is an election year and there could be a power shift in the White House and Congress, what is a potential risk associated with Yong’s strategies?

“Tax avoidance is discouraged by the courts and Congress.”  Is this statement true or false? Please explain.

What are the rewards of tax avoidance? What are the rewards of tax evasion?

What is the difference between tax avoidance and tax evasion?

Describe the business purpose, step-transaction, and substance-over-form doctrines. What types of tax planning strategies may these doctrines inhibit?

Relative to arm’s-length transactions, why do related-person transactions receive more IRS scrutiny?

Explain the assignment of income doctrine. In what situations would this doctrine potentially apply?

What is the constructive receipt doctrine? What types of taxpayers does this doctrine generally affect? For what tax planning strategy is the constructive receipt doctrine a potential limitation?

Several judicial doctrines limit basic tax planning strategies. What are they? Which planning strategies do they limit?

What is an “implicit tax,” and how does it affect a taxpayer’s decision to purchase municipal bonds?

Laurie is thinking about investing in one or several of the following investment options:

• Corporate bonds (ordinary interest paid annually)

• Dividend-paying stock (qualified dividends)

• Life insurance (tax-exempt)

• Savings account

• Growth stock

a) Assuming all of the options earn similar returns before taxes, rank Laurie’s investment options from highest to lowest according to their after-tax returns.

b) Which of the investments employ the deferral and/or conversion tax planning strategies?

c) How does the time period of the investment affect the returns from these alternatives?

d) How do these alternative investments differ in terms of their nontax characteristics?

Under what circumstances would you expect the after-tax return from an investment in a capital asset to approach that of tax-exempt assets (assuming equal before-tax rates of return)?