Exam 4: Maxims of Income Tax Planning

OWB Inc. and Owin Inc. are owned by the same family. OWB's marginal tax rate is 30%, and Owin's marginal tax rate is 21%. OWB has the opportunity to engage in a transaction that will generate $250,000 taxable cash flow. Alternatively, Owin could engage in the transaction. However, Owin would incur an extra $60,000 deductible cash expense with respect to the transaction. Which of the following statements is true?

Mr. Understal has $750,000 to invest and two competing investment opportunities. Investment 1 would pay 9% per year ($67,500 annual before-tax cash flow). Investment 2 would pay 7% per year ($52,500 annual before-tax cash flow). The return on Investment 1 is taxable at Mr. Understal's 35% rate on ordinary income, while the return on Investment 2 is taxable at a 20% preferential rate.Compute the explicit and implicit tax that Mr. Understal would pay with respect to each investment.Which investment results in the greater after-tax cash flow?

Municipal bond investments bear less implicit tax than investments in taxable corporate bonds.

A reduced market rate of return on a tax-favored investment is called an implicit tax.

Which of the following statements about the jurisdiction variable is true?

Which of the following statements about ordinary income and capital gain is true?

The tax character of an item of income depends on how the income is reported on the firm's financial statements.

Mrs. James plans to invest in one of two investment alternatives having the same risk. Investment 1 has a before-tax return of 10% and the income from investment 1 would be taxed at Mrs. James' 35% regular tax rate. Investment 2 has a before-tax return of 8% and the income from investment 2 would be taxed at a 15% preferential rate. Which of the following statements regarding these investment choices is false?

According to the assignment of income doctrine, income must be taxed to the person receiving the cash from an income-generating transaction.

Assume that Congress recently amended the tax law to provide for a maximum 12% rate on interest income from U.S. savings bonds. Compute the tax savings from this preferential rate for:Mrs. Edwin, who has a 15% marginal rate on ordinary income and earned $290 interest on her investment in U.S. savings bonds.Mr. Kalter, who has a 35% marginal rate on ordinary income and earned $290 interest on his investment in U.S. savings bonds.

Corporations, LLCs, and partnerships are all taxable entities.

Hubern Inc. is planning a transaction that will generate $275,000 taxable income and cash inflow. The transaction is structured so that Hubern will receive the cash and report the income this year (year 0). Use Appendix A of your textbook provided to compute the increase in the NPV of the transaction if it can be restructured so that Hubern will receive the cash this year, but report the income one year later (year 1). Hubern's marginal tax rate is 21%, and it uses a 9% discount rate to compute NPV.

Mrs. Stout has a $35,000 capital gain eligible for a 28% preferential tax rate. Which of the following statements is false?

Deduction-shifting transactions usually occur between unrelated taxpayers.

NWR Inc. is structuring a transaction that will require a $200,000 deductible cash expenditure. Which of the following structures is the most effective in terms of the time period variable?

A strategy to shift income from one taxpayer to a different taxpayer reflects the entity variable, while a strategy to shift income from one year to a different year reflects the time period variable.

Gregly Company, which has a 21% marginal tax rate, plans to make an investment that should generate $300,000 annual cash flow/ordinary income. Instead of making the investment directly, Gregly could form a new taxable entity (L'il Greg) to make the investment. L'il Greg's marginal tax rate on the investment income would be only 13%. However, L'il Greg would have to incur a $26,500 annual nondeductible expense associated with the investment that Gregly would not incur.Should Gregly make the investment directly or make it through L'il Greg to maximize after-tax cash flow?Would your answer change if L'il Greg could deduct its $26,500 additional expense?

The income tax consequences of a business transaction depend on which entity engages in the transaction because:

The tax law provides that individuals do not pay tax on the first $250,000 of gain realized on the sale of a principal residence. This rule is an example of the:

A planning strategy that defers a tax cost without deferring the receipt of before-tax cash flows decreases the NPV of the transaction.