Exam 3: Tax Planning Strategies and Related Limitations

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Assuming Jayzee's goal is to minimize his current federal income tax exposure, one can compare the single individual and corporate tax rate schedules to achieve this goal. Since Jayzee has $25,000 of taxable income not related to his sole proprietorship, he is currently in the 15% tax bracket. The task is to allocate the $125,000 between Jayzee and his corporation to minimize his current liability. The lowest corporate tax rate is 15% (taxable income from 0 to $50,000) and is equivalent to Jayzee's marginal tax rate of 15%. To take advantage of the remaining $11,900 of the 15% individual tax bracket ($36,900 - $25,000) and the 15% corporate tax bracket, $11,900 of the profits should be shifted to Jayzee and $50,000 of the expected $125,000 in profits should be retained in the corporation. [$50,000 is the width of the 15% corporate tax bracket.] Jayzee's personal marginal tax rate would now be 25% and his corporation's marginal tax rate would also be 25%. Let's assume that, all things equal, Jayzee prefers to receive the profits personally. To take advantage of Jayzee's 25% personal tax bracket, the next $52,450 of the expected $125,000 in profits should be shifted to Jayzee. [$52,450 is the width of Jayzee's 25% tax bracket]. Jayzee's marginal tax rate would now be 28% and $114,350 of the corporation's profits have been allocated . Continuing this same decision process, the remaining $10,650 of corporate profits should be retained in the corporation and taxed at 25%. In sum, $60,650 of the expected profits are retained in the corporation and $64,350 of the profits are shifted to Jayzee.
This strategy will save Jayzee $6,819.50 calculated as: (a) The tax on $\$ 150,000$ of taxable income reported
$\quad\quad$ by Jayzee assuming that he operates his business
$\quad\quad$ as a sole proprietorship $\quad\quad\quad\quad\quad\quad$$$\$ 35,175.75$$
Less:
(b) The tax on $\$ 89,350$ of taxable income reported
$\quad\quad$ by Jayzee assuming that he incorporates his business $\quad\quad\quad\quad\quad - \$ 18,193.75 \\\\$ and (c) the tax on $\$ 60,650$ profits retained in the corporation $\quad\quad\quad\quad - \$ 10,162.50$
$$= \$ 6,819.50$$

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Richard is engaged in tax evasion. Jeffrey is engaged in tax avoidance. Tax avoidance is the legal act of arranging one's affairs to minimize taxation. The rewards of tax avoidance include maximizing the taxpayer's wealth. It has long been endorsed by the courts and Congress. In contrast to tax avoidance, tax evasion (willful intent to defraud the government) falls outside the confines of legal tax avoidance. The "rewards" of tax evasion include civil and criminal penalties, including large monetary fines and sentencing to federal prison. In many cases there is a clear distinction between avoidance (e.g., not paying tax on municipal bond interest) and evasion (e.g., not paying tax on $10,000 of compensation). In other cases, the line between tax avoidance and evasion is less clear. In these situations, professional judgment, the use of a "smell test," and consideration of the business purpose, step transaction, and substance-over-form doctrines may prove useful.