Tax planning is the arrangement of transactions or investments so as to minimize total taxes. When multiple transactions are involved in a given investment, as with most business projects, then taxes are minimized by calculating the net present value of all the transactions required in the project, including the effect of taxes. Taxation affects the present value of any project or transaction. Therefore, one facet of tax planning is to consider tax costs and tax benefits from a project or transaction as it affects net present value. The tax costs of a transaction are the cash inflow multiplied by the marginal tax rate; likewise, the tax benefit is the tax outflow multiplied by the marginal tax rate.
However, if the marginal tax rate changes during the course of the project or investment or if the tax rules change, then the analysis is more complicated. Hence, tax planning involves a lot of uncertainty. This uncertainty increases the risk in investments that is often compensated for by using a higher discount rate in computing the net present value of the proposed investment. Tax planning involves minimizing tax costs while maximizing tax benefits. Although the taxation of transactions or investments is not the only consideration, focusing only on the tax consequences simplifies the analysis.
There are various ways to lower taxes, but these can be reduced by using 4 different methods, by shifting income and deductions among:
- different taxable entities;
- different types of taxable transactions or sources of income;
- different tax jurisdictions; and
- different tax years.
Tax planning strategies often use a combination of these 4 strategies.
Different entities, such as sole proprietorships, partnerships, limited liability companies, S corporations and C corporations, are taxed at different rates, so choosing the right entity may minimize taxes. For instance, corporations do not pay employment tax, so if a taxpayer organizes his business as an S corporation, he can receive part of his income as a dividend, which is not subject to employment taxes.
Because different sources of income have different tax rates, it is sometimes possible to shift some income that is taxed at a higher rate to income that is taxed at a lower rate. Because tax laws often favor the wealthy, employment income is frequently taxed at the highest rate, placing most of the tax burden on working people, while income that accrues mostly to the wealthy, such as investment income and inherited income, are taxed at much lower rates. Investment income is not subject to employment taxes and inherited income is often tax-free to the recipient. Capital gains on capital investments that are held for longer than 1 year are taxed at an even lower rate. Hence, sometimes it is possible to take advantage of these different taxation rates by changing the character of the income received. For instance, if a taxpayer formed a C corporation for her business, she can arrange to receive lavish fringe benefits, many of which are completely tax-free to the employee and deductible by the corporation. Another method to reduce taxes is by buying tax-deferred or tax-free securities, such as municipal bonds, whose income is tax-free. However, these bonds pay a lower interest rate because of their tax-free status, which imposes an implicit tax in the form of a reduced interest rate because of its preferential tax treatment.
Countries, states, and other types of jurisdictions also have widely differing tax rates. For instance, Ireland has a very low corporate tax rate, so many businesses, even those based in the United States, arrange many of their transactions to take place in low tax countries.
Because the present value of money declines the further into the future that the money is received or paid out, the effect of a tax on income will be less if it occurs further in the future. Likewise, a tax deduction is more valuable if taken sooner rather than later, assuming that tax rates remain unchanged during the relevant time frame. Thus, taxes can be lowered by both postponing taxation of income items to later tax years and accelerating tax deductions to earlier tax years.
Although the IRS has many rules for restricting the shifting of income and deductions to different tax years, there are some legal methods of shifting income or deductions, including:
- using the installment sale method for receiving income from a profitable property sale,
- expensing business deductions immediately under §179 or claiming depreciation over a number of years, and
- using the completed contract method of accounting for revenue earned from long-term contracts.
For instance, if a taxpayer expects to earn more money in the future, then depreciating items over years of higher income would be more desirable than using Section 179 to deduct the items in the year acquired.
Tax Planning Restrictions
Although many methods of tax planning are legal, some taxpayers aggressively take advantage of loopholes in the tax law. However, the IRS may scrutinize any unusual tax planning strategies, which increase the risk of a tax audit or court challenge. The IRS has several tools to negate or minimize tax avoidance procedures, such as IRC §482, which gives the IRS broad powers to reallocate income, deductions, and credits to better reflect the true income to the taxpayer or to minimize the effect of procedures whose main purpose is to avoid taxes.
In tax law, there is also a fundamental assumption that transactions are at-arms length. Hence, related-party transactions are subject to special rules, which apply to transactions between family members, but may also include transactions with closely held corporations, partnerships, and corporations and their affiliates or their parents. IRC §267 disallows tax deductions for losses on the sale or exchange of property between related parties. It also disallows deductions for any unpaid expenses until the payee recognizes the income. Losses or deductions are disallowed even when the transaction was at market value.
Over the years, case law has developed that has also given the IRS broad powers to prevent manipulation of the tax code. One of these doctrines is the business purpose doctrine, which became part of case law in 1935, that allows the IRS to disregard the tax results of any transaction that had no substantial business purpose other than to avoid taxes. For instance, if a corporation leases equipment from a favored political candidate as a means of contributing to the political campaign while taking a deduction on the lease, even though the equipment has no relation to the business of the corporation and the corporation never uses the equipment, then the deduction will be disallowed by the IRS because the lease payment is obviously a non-deductible campaign contribution.
Closely related to the business purpose doctrine is the economic substance doctrine, which examines not only whether a transaction has economic substance, but also the intent of the parties. This doctrine is often applied to leases and tax straddles. Again, if the intention was to avoid taxes and the transaction was devoid of economic substance, then it will be disregarded for tax purposes.
The substance over form doctrine looks at the essential element of the transaction to discover if the transaction was organized mostly for tax purposes. If so, then the substance of the transaction is considered, not its form.
Because of the complexity of the tax code, lawyers, over the years, have devised complicated procedures that involve multiple steps to reduce or eliminate taxes on a transaction, especially in corporate and partnership restructurings or corporate mergers. The step transaction doctrine allows the IRS to disregard the intermediate transactions and to just consider the tax consequences of the final result.
The step transaction doctrine can best illustrated with a simple example. Suppose that the hypothetical transaction A →C is taxable, but A →B and B →C are not. Then taxes can be avoided by transacting A →B and B →C instead of A →C even if they have no economic value as separate steps — the only reason for doing them is to avoid taxes. In this case, the IRS will discern that transaction A →C was the real intention of the 2 separate transactions, and, thus, will disregard the intermediate steps, and tax the A →C transaction accordingly.
The IRS uses 3 tests to determine if the step transaction doctrine is applicable.
- The binding commitment test examines whether there is a binding commitment to perform each step of the transaction.
- The mutual interdependence test examines whether the steps have any significance as independent steps, without regard to the end result.
- This is closely related to the end result test, which examines whether each step of the transaction was only to achieve the end result.
Another common tax dodge is to assign income or deductions to another taxpayer. The assignment of income doctrine allows the IRS to tax the individual or other entity who provides services or owns the capital on which income was paid to another person. For instance, if parents own property that generates income of $10,000 per year, and they are in the 35% tax bracket, then they must pay $3500 on than $10,000 of income. However, if they assign the income to their daughter, who is in the 15% bracket, then the family can save $2000 in taxes. However, the assignment of income doctrine allows the IRS to tax the parents for the income even though they assigned it to their daughter, because they still own the property.
Most of the above doctrines mirror one another, but have developed independently because different courts at different times have developed their own line of reasoning in analyzing these transactions, even as they arrive at similar rulings. While the courts have frequently ruled that taxpayers have the right to arrange their affairs so as to minimize taxes, closing these loopholes does have economic value, because these tax dodges consume some economic resources while thwarting the intent of tax law. Hence, it is beneficial to any economy to minimize this waste of economic resources and to make taxation more equitable, since only wealthy taxpayers can afford the accountants and lawyers that are usually required to concoct these schemes.