Chapter 03 Test Bank

1. Award: 1.
00 point
The goal of tax planning is tax minimization.
 True
 False
The goal of tax planning is maximizing after-tax wealth and achieving the taxpayer's nontax goals.
References
True / False Difficulty: 1 Easy Learning Objective: 03-01 Identify the objectives of basic
tax planning strategies.
2. Award: 1.00 point
Nontax factors do not play an important role in tax planning.
 True
 False
References
True / False Difficulty: 1 Easy Learning Objective: 03-01 Identify the objectives of basic
Virtually every transaction involves the taxpayer and two other parties that have an interest in the tax ramifications of the transaction.
 True
 False
Virtually every transaction involves the taxpayer, the other transacting party, and the government.
References
True / False Difficulty: 2 Medium Learning Objective: 03-01 Identify the objectives of basic
The timing strategy is based on the idea that the location of where the income is taxed affects the tax costs of the income.
 True
 False
The timing strategy is based upon when income is taxed as opposed to where it is taxed.
References
True / False Difficulty: 2 Medium Learning Objective: 03-02 Apply the timing strategy.
In general, tax planners prefer to accelerate deductions.
 True
 False
References
True / False Difficulty: 1 Easy Learning Objective: 03-02 Apply the timing strategy.
The concept of present value is an important part of the timing strategy.
 True
 False
References
True / False Learning Objective: 03-02

Apply the timing strategy.
Difficulty: 1 Easy Learning Objective: 03-03

Apply the concept of present
value to tax planning.
Assuming an after-tax rate of return of 10 percent, John should prefer to pay an expense of $85 today instead of an expense of $100 in
one year. Use Exhibit 3.1.
 True
 False
1 / (1 + 0.10) = 0.909 PV. $100 × 0.909 = $90.90 versus $85.
References
True / False Difficulty: 2 Medium Learning Objective: 03-03 Apply the concept of present
The time value of money suggests that $1 one year from now is worth less than $1 today.
 True
 False
References
True / False Difficulty: 1 Easy Learning Objective: 03-03 Apply the concept of present
The present value concept becomes more important as interest rates increase.
 True
 False
References
Future value can be computed as Future Value = Present Value/(1 + r)n.
 True
 False
Future Value = Present Value × (1 + r)n
References
When considering cash inflows, higher present values are preferred.
 True
 False
References
When considering cash outflows, higher present values are preferred.
 True
 False
References
Tax savings generated from deductions are considered cash inflows.
 True
 False
References
In general, tax planners prefer to defer income. This is an example of the conversion strategy.
 True
 False
Deferring income is an example of the timing strategy.
References


Apply the conversion
strategy.
The timing strategy is particularly effective for cash-basis taxpayers.
 True
 False
References
The timing strategy becomes more attractive as tax rates decrease.
 True
 False
References
The timing strategy becomes more attractive as interest rates (i.e., rates of return) increase.
 True
 False
References
The timing strategy becomes more attractive if a taxpayer is able to accelerate deductions by two or more years (versus one year).
 True
 False
References
One limitation of the timing strategy is the difficulties in accelerating a tax deduction without accelerating the actual cash outflow that
generates the tax deduction.
 True
 False
References
The constructive receipt doctrine is a natural limitation for the conversion strategy.
 True
 False
References

strategy.
Difficulty: 2 Medium Learning Objective: 03-06

Describe basic judicial
doctrines that limit tax
planning strategies.
The constructive receipt doctrine is more of an issue for cash-basis taxpayers.
 True
 False
References


If tax rates will be higher next year, taxpayers should accelerate their deductions regardless of their after-tax rate of return.
 True
 False
References
If tax rates will be lower next year, taxpayers should accelerate their deductions regardless of their after-tax rate of return.
 True
 False
References
If tax rates will be higher next year, taxpayers should defer their income to next year regardless of their after-tax rate of return.
 True
 False
References
The value of a tax deduction is higher for a taxpayer with a lower tax rate.
 True
 False
References


Apply the income-shifting
strategy.
The income-shifting strategy requires taxpayers with varying tax rates.
 True
 False
References
True / False Difficulty: 1 Easy Learning Objective: 03-04 Apply the income-shifting
strategy.
The assignment of income doctrine is a natural limitation to the timing strategy.
 True
 False
The assignment of income doctrine requires income to be taxed to the taxpayer who actually earns it.
References


The business purpose, step-transaction, and substance-over-form doctrines may limit the income-shifting strategy.
 True
 False
References

strategy.

Paying dividends to shareholders is one effective way of shifting income from a corporation to its shareholders.
 True
 False
Because corporations don't get a deduction for dividends paid, paying dividends is not an effective way to shift income.
References
True / False Difficulty: 2 Medium Learning Objective: 03-04 Apply the income-shifting
strategy.
The conversion strategy capitalizes on the fact that tax rates vary across different activities.
 True
 False
References
True / False Difficulty: 1 Easy Learning Objective: 03-05 Apply the conversion strategy.
An investment's time horizon does not affect after-tax rates of return on investments taxed annually.
 True
 False
References
True / False Difficulty: 2 Medium Learning Objective: 03-05 Apply the conversion strategy.
Implicit taxes may reduce the benefits of the conversion strategy.
 True
 False
References
Investors must consider complicit taxes as well as explicit taxes in order to make correct investment choices.
 True
 False
Investors must consider implicit as well as explicit taxes.
References
The business purpose, step-transaction, and substance-over-form doctrines may limit the conversion strategy.
 True
 False
References

strategy.

Tax avoidance is a legal activity that forms the basis of the basic tax planning strategies.
 True
 False
Tax avoidance is legal; tax evasion is not.
References
True / False Difficulty: 1 Easy Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
Tax evasion is a legal activity that forms the basis of the basic tax planning strategies.
 True
 False
References
True / False Difficulty: 2 Medium Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
The downside of tax avoidance includes the potential of stiff monetary penalties and imprisonment.
 True
 False
References
True / False Difficulty: 2 Medium Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
The goal of tax planning generally is to:
 minimize taxes.
 minimize IRS scrutiny.
 maximize after-tax wealth.
 support the federal government.
 None of the choices are correct.
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-01 Identify the objectives of basic
Effective tax planning requires all of these considerations except:
 nontax factors.
 the taxpayer's tax costs of alternative transactions.
 the other party's tax costs of alternative transactions.
 the other party's nontax costs of alternative transactions.
 All of the choices are required considerations.
References
Which is not a basic tax planning strategy?
 income shifting
 timing
 conversion
 arm's length transaction
References
Which of the following tax planning strategies is based on the present value of money?
 Timing
 Tax avoidance
 Income shifting
 Conversion
References
Multiple Choice Difficulty: 1 Easy Learning Objective: 03-02 Apply the timing strategy.
Assuming a positive interest rate, the present value of money suggests:
 $1 today = $1 in one year.
 $1 today > $1 in one year.
 $1 today < $1 in one year.
 $1 today ≤ $1 in one year.
References
Multiple Choice Difficulty: 1 Easy Learning Objective: 03-03 Apply the concept of present
If Joel earns a 10 percent after-tax rate of return, $10,000 received in two years is worth how much today? Use Exhibit 3.1. (Round
discount factor(s) to three decimal places.)
 $10,000
 $9,090
 $8,260
 $11,000
$10,000 × 0.826 (discount factor, two years, 10 percent) = $8,260.
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-03 Apply the concept of present
If Joel earns a 6 percent after-tax rate of return, $12,000 received in two years is worth how much today? Use Exhibit 3.1. (Round discount
factor(s) to three decimal places.)
 $12,000
 $11,370
 $10,680
 $12,720
$12,000 × 0.890 (discount factor, two years, 6 percent) = $10,680.
References
If Lucy earns a 6 percent after-tax rate of return, $8,000 received in four years is worth how much today? Use Exhibit 3.1. (Round discount
factor(s) to three decimal places.)
 $8,000
 $7,544
 $8,989
 $6,336
$8,000 × 0.792 (discount factor, four years, 6 percent) = $6,336.
References
If Lucy earns a 11 percent after-tax rate of return, $10,000 received in four years is worth how much today? Use Exhibit 3.1. (Round
discount factor(s) to three decimal places.)
 $10,000
 $8,924
 $11,609
 $6,590
$10,000 × 0.659 (discount factor, four years, 11 percent) = $6,590.
References
If Nicolai earns an 8 percent after-tax rate of return, $20,000 today would be worth how much to Nicolai in five years? Use future value of
$1. (Round discount factor(s) to four decimal places.)
 $20,000
 $13,620
 $18,520
 $21,600
 None of the choices are correct.
$20,000 × (1.08)5 = $29,387 or $20,000 × 1.4693 = $29,387.
References
If Nicolai earns an 9 percent after-tax rate of return, $17,000 today would be worth how much to Nicolai in five years? Use future value of
$1. (Round discount factor(s) to four decimal places.)
 $17,000
 $11,057
 $15,597
 $18,530
$17,000 × (1.09)5 = $26,157 or $17,000 × 1.5386 = $26,157.
References
If Scott earns a 12 percent after-tax rate of return, $15,000 today would be worth how much to Scott in two years? Use future value of $1.
(Round discount factor(s) to five decimal places.)
 $15,000
 $11,955
 $18,520
 $18,816
$15,000 × (1.12)2 = $18,816 or $15,000 × 1.25440 = $18,816.
References
If Rudy has a 25 percent tax rate and a 6 percent after-tax rate of return, a $30,000 tax deduction in four years will save how much tax in
today's dollars? Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
 $30,000
 $7,500
 $23,760
 $5,940
$30,000 × 0.25 (tax rate) × 0.792 (discount factor, 6 percent, four years) = $5,940.
References
Multiple Choice Learning Objective: 03-02


If Jim invested $100,000 in an annual dividend-paying stock today with a 7 percent return, what investment time period will give Jim the
greatest after-tax return?
 1 year
 5 years
 10 years
 20 years
 All yield the same after-tax return.
Time horizon doesn't affect after-tax rate of return on investments taxed annually.
References


strategy.
If Julius has a 32 percent tax rate and a 10 percent after-tax rate of return, a $40,000 tax deduction in two years will save how much tax
in today's dollars? Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
 $40,000
 $10,573
 $33,040
 $12,800
$40,000 × 0.32 (tax rate) × 0.826 (discount factor, 10 percent, two years) = $10,573.
References


If Julius has a 32 percent tax rate and a 5 percent after-tax rate of return, a $44,000 tax deduction in two years will save how much tax in
 $44,000
 $12,771
 $39,908
 $14,080
$44,000 × 0.32 (tax rate) × 0.907 (discount factor, 5 percent, two years) = $12,771.
References


If Thomas has a 37 percent tax rate and a 6 percent after-tax rate of return, $50,000 of income in five years will cost him how much tax in
 $50,000
 $18,500
 $37,350
 $13,820
$50,000 × 0.37 (tax rate) × 0.747 (discount factor, 6 percent, five years) = $13,820.
References


If Thomas has a 37 percent tax rate and a 9 percent after-tax rate of return, $69,500 of income in five years will cost him how much tax in
 $69,500
 $25,715
 $46,956
 $16,715
$69,500 × 0.37 (tax rate) × 0.65 (discount factor, 9 percent, five years) = $16,715.
References


If Julius has a 22 percent tax rate and a 10 percent after-tax rate of return, $25,000 of income in three years will cost him how much tax
in today's dollars? Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
 $4,131
 $18,775
 $5,500
 $25,000
$25,000 × 0.22 (tax rate) × 0.751 (discount factor, 10 percent, three years) = $4,131.
References


If Julius has a 22 percent tax rate and a 12 percent after-tax rate of return, $61,000 of income in three years will cost him how much tax in
 $9,555
 $43,432
 $13,420
 $61,000
$61,000 × 0.22 (tax rate) × 0.712 (discount factor, 12 percent, three years) = $9,555.
References


Which of the following increases the benefits of income deferral?
 Increasing tax rates
 Smaller after-tax rate of return
 Larger after-tax rate of return
 Smaller magnitude of transactions
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-02 Apply the timing strategy.
Which of the following decreases the benefits of accelerating deductions?
 Decreasing tax rates
 Smaller after-tax rate of return
 Larger after-tax rate of return
 Larger magnitude of transactions
References
Which of the following does not limit the benefits of deferring income?
 A taxpayer with severe cash flow needs
 If continuing an investment would generate a low rate of return
 If continuing an investment would subject the taxpayer to unnecessary risk
References
The constructive receipt doctrine:
 is particularly restrictive for accrual-basis taxpayers.
 causes income to be recognized before it is actually received.
 causes income to be recognized after it is actually received.
 applies equally to income and expenses.
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-06 Describe basic judicial
doctrines that limit tax planning strategies.
Rolando's employer pays year-end bonuses each year on December 31. Rolando, a cash-basis taxpayer, would prefer not to pay tax on
his bonus this year. So, he leaves town on December 31, 2019, and doesn't pick up his check until January 2, 2020. When should
Rolando report his bonus?
 2020
 2019
 Rolando can choose the year to report the income
 It does not matter
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-06 Describe basic judicial
doctrines that limit tax planning strategies.
If tax rates are decreasing:
 taxpayers should accelerate income.
 taxpayers should defer deductions.
 taxpayers should defer income.
 taxpayers should defer deductions and accelerate income.
References
If tax rates are decreasing:
 taxpayers should accelerate deductions.
 taxpayers should defer deductions and accelerate income.
References
If tax rates are increasing:
 taxpayers should defer income.
 you need more information to make a recommendation.
References
Which of the following is not required to determine the best timing strategy?
 The taxpayer's after-tax rate of return
 The taxpayer's tax rate this year
 The taxpayer's tax rate in future years
 The taxpayer's tax rate last year
References
Which of the following is an example of the timing strategy?
 A corporation paying its shareholders a $20,000 dividend.
 A parent employing her child in the family business.
 A taxpayer gifting stock to his children.
 A cash-basis business delaying billing its customers until after year-end.
References
Which of the following is an example of the timing strategy?
 A cash-basis taxpayer paying all outstanding bills by year-end.
 A parent employing her child in the family business.
 A business paying its owner a $30,000 salary.
 A taxpayer investing in a tax-preferred investment.
References
Which of the following does not limit the income-shifting strategy?
 Assignment of income doctrine
 Business purpose doctrine
 Substance-over-form doctrine
 Step-transaction doctrine
References

strategy.

A taxpayer paying his 10-year-old daughter $50,000 a year for consulting likely violates which doctrine?
 Constructive receipt doctrine
 Implicit tax doctrine
 Substance-over-form doctrine
References

strategy.

A taxpayer instructing her son to collect rent checks for the taxpayer's property and to report this as taxable income on the son's tax
return violates which doctrine?
 Implicit tax doctrine
 Assignment of income doctrine
References

strategy.

Which of the following is needed to implement the income-shifting strategy?
 Taxpayers with varying tax rates
 Decreasing tax rates
 Unrelated taxpayers
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-04 Apply the income-shifting
strategy.
A common income-shifting strategy is to:
 shift income from low tax rate taxpayers to high tax rate taxpayers.
 shift deductions from low tax rate taxpayers to high tax rate taxpayers.
 shift deductions from high tax rate taxpayers to low tax rate taxpayers.
 accelerate tax deductions.
References
strategy.
Jason's employer pays year-end bonuses each year on December 31. Jason, a cash-basis taxpayer, would prefer not to pay tax on his
bonus this year (and actually would prefer his daughter to pay tax on the bonus). So, he leaves town on December 31, 2019, and has his
daughter, Julie, pick up his check on January 2, 2020. Who reports the income and when?
 Julie in 2020
 Julie in 2019
 Jason in 2019
 Jason in 2020
References
Multiple Choice Learning Objective: 03-02 Learning Objective: 03-06 Describe basic judicial
Apply the timing strategy. doctrines that limit tax planning strategies.

strategy.
Which of the following is more likely to receive IRS scrutiny under the assignment of income doctrine?
 A parent employing her child in the family business.
 A taxpayer gifting stock to his children.
 A cash-basis business delaying billing its customers until after year-end.
References

strategy.

Which of the following is an example of the income-shifting strategy?
 A corporation paying its owner a $20,000 salary.
 A high tax rate taxpayer investing in tax-exempt municipal bonds.
 A cash-basis business delaying billing its customers until after year-end.
References
strategy.
Which of the following is an example of the conversion strategy?
 A corporation paying its owner a $20,000 salary.
 A high tax rate taxpayer investing in tax exempt municipal bonds.
 A cash-basis business delaying billing its customers until after year end.
References
Multiple Choice Difficulty: 2 Medium Learning Objective: 03-05 Apply the conversion strategy.
Which of the following may limit the conversion strategy?
 Implicit taxes
 Assignment of income doctrine
 Activities with preferential tax rates
References

strategy.

Assume that Bill's marginal tax rate is 32 percent. If corporate bonds pay 8 percent interest, what interest rate would a municipal bond
have to offer for Bill to be indifferent between the two bonds?
 32.00 percent
 10.40 percent
 8.00 percent
 7.00 percent
8% × (1 − 0.32) = 5.44%.
References
Assume that Bill's marginal tax rate is 32 percent. If corporate bonds pay 9 percent interest, what interest rate would a municipal bond
have to offer for Bill to be indifferent between the two bonds? (Do not round your final answer.)
 32.00 percent
 11.70 percent
 9.00 percent
 8.00 percent
 6.12 percent
9% × (1 − 0.32) = 6.12%.
References
Assume that John's marginal tax rate is 37 percent. If a city of Austin bond pays 6 percent interest, what interest rate would a corporate
bond have to offer for John to be indifferent between the two bonds?
 37.00 percent
 9.52 percent
 6.00 percent
 3.78 percent
6% / (1 − 0.37) = 9.52%.
References
Assume that John's marginal tax rate is 17 percent. If a city of Austin bond pays 9 percent interest, what interest rate would a corporate
bond have to offer for John to be indifferent between the two bonds?
 25.50 percent
 10.84 percent
 9.00 percent
 7.47 percent
9% / (1 − 0.17) = 10.84%.
References
Assume that Larry's marginal tax rate is 24 percent. If corporate bonds pay 10 percent interest, what interest rate would a municipal bond
have to offer for Larry to be indifferent between the two bonds?
 24.00 percent
 12.00 percent
 10.00 percent
 7.60 percent
10% × (1 − 0.24) = 7.60%.
References
Assume that Larry's marginal tax rate is 24 percent. If corporate bonds pay 9 percent interest, what interest rate would a municipal bond
have to offer for Larry to be indifferent between the two bonds?
 24.00 percent
 10.76 percent
 9.00 percent
 6.84 percent
9.00% × (1 − 0.24) = 6.84%.
References
Assume that Lavonia's marginal tax rate is 22 percent. If a city of Tampa bond pays 5 percent interest, what interest rate would a
corporate bond have to offer for Lavonia to be indifferent between the two bonds?
 22 percent
 5 percent
 7 percent
 3.9 percent
5% / (1 − 0.22) = 6.41%.
References
Assume that Lavonia's marginal tax rate is 22 percent. If a city of Tampa bond pays 8.4 percent interest, what interest rate would a
corporate bond have to offer for Lavonia to be indifferent between the two bonds?
 22.00 percent
 8.40 percent
 10.40 percent
 7.30 percent
8.40% / (1 − 0.22) = 10.77%.
References
Assume that Marsha is indifferent between investing in a city of Destin bond that pays 6 percent interest and a corporate bond that pays
8 percent interest. What is Marsha's marginal tax rate?
 50 percent
 40 percent
 30 percent
 20 percent
8% × (1 − marginal tax rate) = 6%; marginal tax rate = 1 − (6% / 8%) = 25%.
References
Assume that Marsha is indifferent between investing in a city of Destin bond that pays 4 percent interest and a corporate bond that pays
5.5 percent interest. What is Marsha's marginal tax rate? (Do not round intermediate computations.)
 54.54 percent
 42.27 percent
 32.27 percent
 21.14 percent
5.5% × (1 − marginal tax rate) = 4%; marginal tax rate = 1 − (4% / 5.5%) = 27.27%.
References
Assume that Javier is indifferent between investing in a city of El Paso bond that pays 5 percent interest and a corporate bond that pays
6.25 percent interest. What is Javier's marginal tax rate?
 50 percent
 40 percent
 30 percent
 20 percent
6.25% × (1 − marginal tax rate) = 5%; marginal tax rate = 1 − (5% / 6.25%) = 20%.
References
Assume that Javier is indifferent between investing in a city of El Paso bond that pays 3.55 percent interest and a corporate bond that
pays 5.4 percent interest. What is Javier's marginal tax rate?
 104.22 percent
 54.26 percent
 44.26 percent
5.4% × (1 − marginal tax rate) = 3.55%; marginal tax rate = 1 − (3.55%/5.4%) = 34.26%.
References
Assume that Lucas's marginal tax rate is 32 percent and his tax rate on dividends is 15 percent. If a dividend-paying stock (with no growth
potential) pays an 8 percent dividend yield, what interest rate would a municipal bond have to offer for Lucas to be indifferent between
the two investments from a cash-flow perspective?
 32.00 percent
 15.00 percent
 8.00 percent
 6.80 percent
8% × (1 − 0.15) = 6.80%.
References
Assume that Lucas's marginal tax rate is 22 percent and his tax rate on dividends is 11 percent. If a dividend-paying stock (with no growth
potential) pays an 6.6 percent dividend yield, what interest rate would a municipal bond have to offer for Lucas to be indifferent between
 22.00 percent
 10.00 percent
 6.60 percent
 5.87 percent
6.6% × (1 − 0.11) = 5.87%.
References
Assume that Keisha's marginal tax rate is 37 percent and her tax rate on dividends is 15 percent. If a city of Atlanta bond pays 7.65
percent interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Keisha to be indifferent
between the two investments from a cash-flow perspective?
 15.00 percent
 10.00 percent
 9.00 percent
 7.65 percent
Dividend yield × (1 − 0.15) = 7.65%; Dividend yield = 7.65% / (1 − 0.15) = 9.00%.
References
Assume that Keisha's marginal tax rate is 37 percent and her tax rate on dividends is 25 percent. If a city of Atlanta bond pays 5.7 percent
interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Keisha to be indifferent between
 25.00 percent
 8.60 percent
 7.60 percent
 5.70 percent
Dividend yield × (1 − 0.25) = 5.70%; Dividend yield = 5.70% / (1 − 0.25) = 7.60%.
References
Assume that Shavonne's marginal tax rate is 37 percent and her tax rate on dividends is 15 percent. If a corporate bond pays 10.20
percent interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Shavonne to be
indifferent between the two investments from a cash-flow perspective?
 6.43 percent
 7.56 percent
 10.20 percent
 15.00 percent
After-tax yield of the corporate bond is 10.20% × (1 − 0.37) = 6.43%. The after-tax yield of the dividend-paying stock must be 6.43 percent.
Therefore, 6.43% = Yield × (1 − 0.15) and Yield = 7.56%.
References
Assume that Shavonne's marginal tax rate is 37 percent and her tax rate on dividends is 15 percent. If a corporate bond pays 7.8 percent
interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Shavonne to be indifferent
between the two investments from a cash-flow perspective?
 4.65 percent
 5.78 percent
 7.80 percent
 15.00 percent
After-tax yield of the corporate bond is 7.8% × (1 − 0.37) = 4.91%; The after-tax yield of the dividend-paying stock must be 4.91 percent.
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Assume that Will's marginal tax rate is 32 percent and his tax rate on dividends is 15 percent. If a dividend-paying stock (with no growth
potential) pays a dividend yield of 8 percent, what interest rate must the corporate bond offer for Will to be indifferent between the two
investments from a cash-flow perspective?
 12 percent
 11 percent
 10 percent
 8 percent
After-tax yield of the dividend-paying stock is 8% × (1 − 0.15) = 6.80%. The after-tax yield of the corporate bond must be 6.80 percent.
Therefore, 6.80% = Yield × (1 − 0.32) and Yield = 10%.
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Assume that Will's marginal tax rate is 35 percent and his tax rate on dividends is 15 percent. If a dividend-paying stock (with no growth
potential) pays a dividend yield of 9.8 percent, what interest rate must the corporate bond offer for Will to be indifferent between the two
investments from a cash-flow perspective?
 15.07 percent
 14.32 percent
 10.07 percent
After-tax yield of the dividend-paying stock is 9.80% × (1 − 0.15) = 8.33%; The after-tax yield of the corporate bond must be 8.33 percent.
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Assume that Jose is indifferent between investing in a corporate bond that pays 10 percent interest and a stock with no growth potential
that pays an 8 percent dividend yield. Assume that the tax rate on dividends is 15 percent. What is Jose's marginal tax rate?
 47 percent
 37 percent
 32 percent
 15 percent
After-tax yield of dividend-paying stock is 8% × (1 − 0.15) = 6.80%. The after-tax yield of the bond must be 6.80 percent. Therefore, 6.80%
= 10% × (1 − marginal tax rate) and marginal tax rate = 32%.
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Assume that Jose is indifferent between investing in a corporate bond that pays 10 percent interest and a stock with no growth potential
that pays an 10 percent dividend yield. Assume that the tax rate on dividends is 15 percent. What is Jose's marginal tax rate? (Do not
round intermediate computations.)
 30.20 percent
 20.40 percent
 7.40 percent
After-tax yield of dividend-paying stock is 10.00% × (1 − 0.15) = 8.50%; The after-tax yield of the bond must be 8.50 percent. Therefore,
8.50% = 10% × (1 − marginal tax rate) and marginal tax rate = 15.00%.
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Assume that Juanita is indifferent between investing in a corporate bond that pays 10.20 percent interest and a stock with no growth
potential that pays a 6 percent dividend yield. Assume that the tax rate on dividends is 15 percent. What is Juanita's marginal tax rate?
 50 percent
 40 percent
 30 percent
 15 percent
After-tax yield of dividend-paying stock is 6% × (1 − 0.15) = 5.10%. The after-tax yield of the bond must be 5.10 percent. Therefore, 5.10% =
10.20% × (1 − marginal tax rate) and marginal tax rate = 50%.
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Assume that Juanita is indifferent between investing in a corporate bond that pays 12.60 percent interest and a stock with no growth
potential that pays a 8.40 percent dividend yield. Assume that the tax rate on dividends is 15 percent. What is Juanita's marginal tax
rate? (Do not round intermediate computations.)
 33.09 percent
 22.85 percent
 11.43 percent
After-tax yield of dividend-paying stock is 8.40% × (1 − 0.15) = 7.14%; The after-tax yield of the bond must be 7.14 percent. Therefore, 7.14%
= 12.60% × (1 − marginal tax rate) and marginal tax rate = 43.33%.
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If Tom invests $60,000 in a taxable corporate bond that provides a 5 percent before-tax return, how much will Tom's investment be worth
in either 8 or 20 years from now when the bond matures? Assume Tom's marginal tax rate is 35 percent.
 $88,647; $159,198
 $92,782; $178,414
 $79,621; $121,716
 $77,495; $113,750
ATRR = 0.0325 (0.05 × (1 − 0.35)); $60,000 × (1.0325)8 = $77,495; $60,000 × (1.0325)20 = $113,750.
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If Tom invests $115,000 in a taxable corporate bond that provides a 6 percent before-tax return, how much will Tom's investment be
worth in either 8 or 20 years from now when the bond matures? Assume Tom's marginal tax rate is 35 percent.
 $183,293; $368,821
 $171,466; $311,841
 $158,305; $255,143
 $156,179; $247,177
ATRR = 0.039 (0.06 × (1 − 0.35)); $115,000 × (1.039)8 = $156,179; $115,000 × (1.039)20 = $247,177.
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The income-shifting and timing strategies are examples of:
 tax avoidance.
 tax evasion.
 illegal taxpayer strategies.
 All of the choices are correct.
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Multiple Choice Difficulty: 1 Easy Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
A taxpayer earning income in "cash" and not reporting it as taxable income is an example of:
 tax avoidance.
 tax evasion.
 conversion.
 income shifting.
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Multiple Choice Difficulty: 1 Easy Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
Investing in municipal bonds to avoid paying tax on interest earned and to earn a higher after-tax yield is an example of:
 conversion.
 tax evasion.
 timing.
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strategy.

Contrast tax avoidance and
tax evasion.
Paying "fabricated" expenses in high tax rate years is an example of:
 conversion.
 tax evasion.
 timing.
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Multiple Choice Difficulty: 2 Medium Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
Danny argues that tax accountants suffer from one-mindedness in their attempts at tax planning (i.e., reducing taxes at all costs). Is
Danny's view of tax planning correct—i.e., does he understand what the goal of tax planning is? Please elaborate.
Danny has an incomplete view of the goals of tax planning. In general terms, the goal of tax planning is to maximize the taxpayer's after-
tax wealth while simultaneously achieving the taxpayer's nontax goals. Maximizing after-tax wealth is not necessarily the same as tax
minimization. Specifically, maximizing after-tax wealth requires one to consider both the tax and nontax costs and benefits of alternative
transactions, whereas tax minimization focuses solely on a single cost (i.e., taxes). Indeed, if the goal of tax planning were simply to
minimize taxes, the simplest way to achieve this goal would be to earn no income at all.
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Essay Difficulty: 3 Hard Learning Objective: 03-01 Identify the objectives of basic
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.
The three basic tax strategies discussed basically exploit the variation of taxation across different dimensions. The timing strategy
exploits the variation in taxation across time—i.e., the "real" tax costs of income decrease as taxation is deferred; the "real" tax savings
associated with tax deductions increase as tax deductions are accelerated. The income-shifting strategy exploits the variation in taxation
across taxpayers or jurisdictions (e.g., by shifting income to low tax rate taxpayers and tax deductions to high tax rate taxpayers). Finally,
the conversion strategy exploits the variation in taxation across activities.
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Essay Difficulty: 3 Hard Learning Objective: 03-01 Identify the objectives of basic
There are two basic timing-related tax rate strategies. What are they? What is the intent of each strategy? In which situations do the tax
rate and timing strategies provide conflicting recommendations? What information do you need to determine the appropriate action?
The two basic timing-related tax rate strategies are to recognize tax deductions during high tax rate years and to recognize taxable
income during low tax rate years. The intent of the deduction strategy is to increase the tax savings associated with the tax deductions.
The intent of the income strategy is to decrease the tax costs associated with the income.
The tax rate and timing strategies provide conflicting recommendations when tax rates are increasing. To determine the appropriate
action, you need the taxpayer's after-tax rate of return and the amount of the tax rate increase.
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Essay Difficulty: 3 Hard Learning Objective: 03-02 Apply the timing strategy.
Based only on the information provided for each scenario, determine whether Eddy or Scott will benefit more from using the timing
strategy and why there will be a benefit to that person. Use Exhibit 3.1.
a. Eddy has a 40 percent tax rate. Scott has a 30 percent tax rate.
b. Eddy and Scott each have a 40 percent tax rate. Eddy has $10,000 of income that could be deferred; Scott has $20,000 of income
that could be shifted.
c. Eddy and Scott each have a 40 percent tax rate and $20,000 of income that could be deferred. Eddy's after-tax rate of return is 8
percent. Scott's after-tax rate of return is 10 percent.
d. Eddy and Scott each have a 40 percent tax rate, $20,000 of income that could be deferred, and an after-tax rate of return of 10
percent. Eddy can defer income up to three years. Scott can defer income up to two years.
a. Eddy, because the benefits of the timing strategy increase with tax rates.
b. Scott, because the benefits of the timing strategy increase with the magnitude of the transaction.
c. Scott, because the benefits of the timing strategy increase with the after-tax rate of return.
d. Eddy, because the benefits of the timing strategy increase with the deferral period.
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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 three decimal places.)
a. Kristi has a 40 percent tax rate and can defer $20,000 of income. Cindy has a 30 percent tax rate and can defer $30,000 of income.
b. Kristy has a 30 percent tax rate and a 10 percent after-tax rate of return and can defer $25,000 of income for three years. Cindy has a
40 percent tax rate and an 8 percent after-tax rate of return and can defer $20,000 of income for four years..
a. Cindy, because she can defer $9,000 of tax ($30,000 × 30%), whereas Kristi can only defer $8,000 of tax ($20,000 × 40%).
b. Cindy.
If Kristy defers the $25,000 of taxable income for three years, it will save her $1,867.50 tax in today's dollars.
Current tax on $25,000 at 30 percent = $7,500
Present value of tax on $25,000 income taxed at 30 percent in three years:
$25,000 × 0.30 × 0.751 (discount factor, three years, 10 percent) = $5,632.50

Kristy's savings = $7,500 − $5,632.50 = $1,867.50
If Cindy defers the $20,000 of taxable income for four years, it will save her $2,120 tax in today's dollars.
Present value of tax on $20,000 income taxed at 40 percent in four years:
$20,000 × 0.40 × 0.735 (discount factor, four years, 8 percent) = $5,880

Cindy's savings = $8,000 − $5,880 = $2,120
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Essay Learning Objective: 03-02

Difficulty: 3 Hard Learning Objective: 03-03

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 three decimal places.)
a. Kristi has a 40 percent tax rate and can defer $30,000 of income. Cindy has a 30 percent tax rate and can defer $40,000 of income.
b. Kristy has a 30 percent tax rate and a 12 percent after-tax rate of return and can defer $35,000 of income for three years. Cindy has a
40 percent tax rate and an 10 percent after-tax rate of return and can defer $30,000 of income for four years.
a. Cindy, because she can defer $12,000 of tax ($40,000 × 30%), whereas Kristi can only defer $12,000 of tax ($30,000 × 40%).
b. Cindy.
If Kristy defers the $35,000 of taxable income for three years, it will save her $3,024 tax in today's dollars.
Present value of tax on $35,000 income taxed at 30 percent in three years:
$35,000 × 0.30 × 0.712 (discount factor, three years, 12 percent) = $7,476.00

Kristy's savings = $10,500 − $7,476.00 = $3,024.00
If Cindy defers the $30,000 of taxable income for four years, it will save her $3,804 tax in today's dollars.
Present value of tax on $30,000 income taxed at 40 percent in four years:
$30,000 × 0.40 × 0.683 (discount factor, four years, 10 percent) = $8,196

Cindy's savings = $12,000 − $8,196 = $3,804
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David, an attorney and cash-basis taxpayer, is new to the concept of tax planning and recently learned of the timing strategy. To
implement the timing strategy, David plans to establish a new policy that allows his clients to wait up to five years to pay their attorney
fees. Assume that David expects his marginal tax rates to remain constant over the foreseeable future. What is wrong with this strategy?
While this plan defers the taxation on his fees, it also delays David's receipt of the fees. Assuming that David doesn't charge his clients
any interest on their delayed payment, this plan will reduce the present value of taxes paid on the fees and the present value of the fees.
The decrease in the present value of the fees will exceed the decrease in the present value of the tax paid on the fees. In addition, by
delaying payment, David may increase the likelihood that many of his clients will not pay his fees. In sum, this is not a good plan.
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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?
Assuming an investor can earn a positive return (e.g., 5 percent), $1 invested today should be worth $1.05 in one year. Hence, $1 today is
equivalent to $1.05 in one year.
Taxes paid are cash outflows, and tax savings generated from tax deductions can be thought of as cash inflows. With this perspective,
the timing of when a taxpayer pays tax on income or receives a tax deduction for an expenditure obviously affects the present value of
the taxes paid (i.e., a cash outflow) or tax savings received (i.e., a cash inflow).
The timing strategy exploits this concept.
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Luther was very excited to hear about the potential tax savings from shifting income from his corporation to himself. The next day he had
his corporation declare a $30,000 dividend to him. Is this an effective income-shifting strategy? If so, why? If not, why not? What
recommendations do you have for Luther?
Because corporations do not get a tax deduction for dividends paid, paying dividends is not an effective way to shift income. Instead,
paying dividends results in "double taxation"—the profits generating the dividends are taxed first at the corporate level, and then the
dividends are taxed at the shareholder level. Luther should attempt to shift income from the corporation to himself via methods that
generate tax deductions at the corporate level (e.g., compensation to Luther, rent paid to Luther, interest paid to Luther, etc.).
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Essay Difficulty: 3 Hard Learning Objective: 03-04 Apply the income-shifting

strategy.
Compare and contrast the constructive receipt doctrine and the assignment of income doctrine.
In what situations do these doctrines apply? What tax planning strategies does each doctrine limit?
The constructive receipt doctrine limits income deferral (i.e., the timing strategy) for cash-basis taxpayers. Unlike accrual-method
taxpayers, cash-basis taxpayers report income for tax purposes when the income is received (in the form of cash, property, services, etc.).
The cash basis affords taxpayers some leeway in timing when to recognize income because, to some extent, taxpayers can control when
they receive income (e.g., by accelerating or deferring billing their clients). The constructive receipt doctrine provides that a taxpayer
must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has
been credited to the taxpayer's account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the
income's availability, and there are no restrictions on the taxpayer's control over the income.
The assignment of income doctrine requires income to be taxed to the taxpayer that actually earns the income. Merely assigning income
(e.g., someone's paycheck or dividend) to another taxpayer does not transfer the tax liability associated with the income. The implication
of the assignment of income doctrine is that to shift income to a taxpayer, the taxpayer must actually earn the income. Thus, the
assignment of income doctrine limits the income-shifting strategy. Compared to the constructive receipt doctrine, which affects when
income is taxed, the assignment of income doctrine affects to whom the income is taxed.
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Essay Learning Objective: 03-02 Learning Objective: 03-06 Describe basic judicial
Apply the timing strategy. doctrines that limit tax planning strategies.

strategy.
Lucinda is contemplating a long-range planning strategy that will allow her to defer sizable portions of her income for 10 years. What type
of planning strategy is she contemplating? What are some potential risks associated with this type of strategy?
Lucinda is contemplating a long-term timing strategy. One risk to this type of strategy is that changes in the control of the White House
and Congress may result in a fundamental shift in tax policy. Tax rate changes are rather frequent, as lawmakers use them as an integral
part of fiscal or economic policy initiatives (e.g., to raise revenue, stimulate the economy, etc.). The risk to Lucinda is that newly elected
officials will change the tax system in a way that eliminates the benefits of her tax planning strategies (e.g., increasing tax rates in the
future may reduce or eliminate the benefits of income deferral).
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Jared, a tax novice, has recently learned of several foreign tax havens (i.e., countries with low tax rates). He is considering locating his
manufacturing operations in one of these countries solely based on their low tax rates. What types of taxes is Jared ignoring? Explain
how these other taxes may affect the viability of Jared's choice to locate in a foreign tax haven.
The concept of implicit taxes suggests that the demand for tax-advantaged activities increases the costs associated with these activities,
thereby reducing the pretax returns of these activities and the advantages of the conversion strategy. For example, implicit taxes may
reduce or eliminate the advantages of tax-preferred investments (e.g., municipal bonds, or investments taxed at preferential tax rates) by
decreasing the pretax rate of returns for these investments. Likewise, the demand for workers, services, property, etc. in low tax rate
jurisdictions (foreign country or low-tax state) may increase the costs associated with operating a business in these jurisdictions such that
the tax advantages of locating in these jurisdictions are offset by nontax costs. Thus, Jared should carefully consider the implicit taxes of
locating in a foreign tax haven.
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Essay Difficulty: 3 Hard Learning Objective: 03-05 Apply the conversion strategy.
Richard recently received $10,000 of compensation for some consulting work (paid in cash). Jeffrey recently received $10,000 of interest
income from city of Dallas bonds. Both taxpayers report no taxable income from these transactions. Is this considered tax avoidance or
tax evasion? What is the difference, if any, between the two?
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.
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Essay Difficulty: 3 Hard Learning Objective: 03-07 Contrast tax avoidance and tax
evasion.
Antonella works for a company that pays a year-end bonus in December of each year. Assume that Antonella expects to receive a
$20,000 bonus in December this year, her tax rate is 30 percent, and her after-tax rate of return is 8 percent. If Antonella's employer paid
her bonus on January 1 of next year instead of in December, how much would this action save Antonella in today's tax dollars? If
Antonella's tax rate increased to 32 percent next year, would receiving the bonus in January still be advantageous? Use Exhibit 3.1.
If Antonella receives the $20,000 in December, she would have to pay $6,000 in tax in today's dollars. If Antonella receives the $20,000
on January 1, she would have to pay $6,000 in tax in one year. The present value of this payment is $5,556 ($6,000 × 0.926 (discount
factor, one year, 8 percent)). Thus, receiving the payment on January 1 will save Antonella $444 ($6,000 − $5,556).
If her tax rate increased to 32 percent next year, Antonella would have to pay $6,400 of tax in one year ($20,000 × 0.32). The present
value of this payment is $5,926.40 ($6,400 × 0.926 (discount factor, one year, 8 percent)). Thus, receiving the payment on January 1 will
save Antonella $473.60 ($6,400 − $5,926.40) and would still be advantageous.
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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 24 percent.
His tax rate next year will be 32 percent. His after-tax rate of return is 8 percent. When should Joe Harry pay the $20,000 fees and why?
Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
If Joe Harry pays the $20,000 in December, the $20,000 tax deduction will save him $4,800 (i.e., $20,000 × 0.24 = $4,800).
If Joe Harry pays the $20,000 in January, the $20,000 tax deduction will save him $6,400 on next year's tax return (i.e., assuming in one
year). The $6,400 tax savings in one year has a present value of $5,926.40 ($6,400 × 0.926 (discount factor, one year, 8 percent)). Thus,
Joe Harry should pay the $20,000 in January because it saves him $1,126.40 in tax in today's dollars.
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Joe Harry, a cash-basis taxpayer, owes $10,000 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 24 percent.
His tax rate next year will be 32 percent. His after-tax rate of return is 5 percent. When should Joe Harry pay the $10,000 fees and why?
Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
If Joe Harry pays the $10,000 in December, the $10,000 tax deduction will save him $2,400 (i.e., $10,000 × 0.24 = $2,400).
If Joe Harry pays the $10,000 in January, the $10,000 tax deduction will save him $3,200 on next year's tax return (i.e., assuming in one
year). The $3,200 tax savings in one year has a present value of $3,046.40 ($3,200 × 0.952 (discount factor, one year, 5 percent)). Thus,
Joe Harry should pay the $10,000 in January because it saves him $646.40 in tax in today's dollars.
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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 32 percent and
his after-tax rate of return is 10 percent. What tax rate next year will make Rodney indifferent between paying the $40,000 this year or
next year? Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
If Rodney pays the $40,000 in December, the $40,000 tax deduction will save him $12,800 (i.e., $40,000 × 0.32 = $12,800).
If Rodney pays the $40,000 in January, the tax savings in today's dollars is computed as:
Tax savings = $40,000 × tax rate × 0.909 (discount factor, one year, 10 percent).
For Rodney to be indifferent between paying the $40,000 in December or January, paying the $40,000 in January must generate
$12,800 in tax savings. One can use this information to solve for next year's tax rate.
Tax savings = $40,000 × tax rate × 0.909 (discount factor, one year, 10 percent) = $12,800
Tax rate = ($12,800 / $40,000) × (1 / 0.909) = 35.20%
Alternatively, $40,000 × 0.909 = $36,360. $36,360 × tax rate = $12,800. $12,800 / $36,360 = 35.20%.
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Rodney, a cash-basis taxpayer, owes $65,000 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 32 percent and
his after-tax rate of return is 5 percent. What tax rate next year will make Rodney indifferent between paying the $65,000 this year or
next year? Use Exhibit 3.1. (Round discount factor(s) to three decimal places.)
If Rodney pays the $65,000 in December, the $65,000 tax deduction will save him $20,800 (i.e., $65,000 × 0.32 = $20,800).
If Rodney pays the $65,000 in January, the tax savings in today's dollars is computed as:
Tax savings = $65,000 × tax rate × 0.952 (discount factor, one year, 5 percent).
For Rodney to be indifferent between paying the $65,000 in December or January, paying the $65,000 in January must generate
$20,800 in tax savings. One can use this information to solve for next year's tax rate.
Tax savings = $65,000 × tax rate × 0.952 (discount factor, one year, 5 percent) = $20,800
Tax rate = ($20,800/$65,000) × (1/0.952) = 33.61%
Alternatively, $65,000 × 0.952 = $61,880. $61,880 × tax rate = $20,800. $20,800/$61,880 = 33.61%.
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Troy is not a very astute investor. He has a knack for investing in losing stocks. In his latest investment move, he has realized a loss of
about $40,000 (original basis of $50,000; current fair market value of $10,000) in High Tech, Incorporated The good news is that unlike
prior years, he actually has $45,000 of gains that he can use to offset the loss. Troy is considering either selling the High Tech,
Incorporated stock to his sister, Louise, or on the stock market. Which should he choose and why? Please explain why the IRS may treat
the two transactions differently.
If Troy sells the stock to his sister, by tax law, he will not be able to deduct the loss. Thus, he should sell the stock on the stock market.
The two transactions are treated differently because the sale on the stock market is considered an arm's length transaction whereas the
sale to Louise is considered a related-party transaction.
In arm's length transactions, each transacting party negotiates for his or her own benefit. In contrast, taxpayers engaged in related-party
transactions are much more willing to negotiate for the common good of the related parties and to the detriment of the IRS. Accordingly,
the IRS pays special attention to related-party transactions (and even disallows losses in transactions involving related parties).
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strategy.
O'Reilly is a masterful lottery player. The megamillion jackpot is now up to $200 million. If O'Reilly wins the jackpot, he has a choice of
receiving $200 million in five years or a smaller lump sum now. Advise O'Reilly on his choice under the following scenarios. Which option
should he take and why? Use Exhibit 3.1.
a. O'Reilly's after-tax return is 10 percent. If he chooses the current lump-sum option, the lottery will pay him $130 million.
b. O'Reilly's after-tax return is 10 percent. His current tax rate will be 35 percent if he receives the lottery payment now. His expected
tax rate in five years will be 40 percent. If he chooses the current lump-sum option, the lottery will pay him $100 million.
a. If O'Reilly takes the current lump-sum option, he will receive $130 million. The $200 million received in five years will be worth
$124.2 million in today's dollars (i.e., $200 million × 0.621 (discount factor, five years, 10 percent)). O'Reilly should take the $130
million today.
b. If O'Reilly takes the current lump-sum option, he will receive $100 million before taxes and $65 million after taxes (i.e., $100 million ×
(1 − 0.35)). If he chooses the $200 million in five years, he will receive $120 million after taxes in five years (i.e., $200 million × (1 −
0.40)). In today's dollars the $120 million is worth $74.52 million (i.e., $120 million × 0.621 (discount factor, five years, 10 percent)).
O'Reilly should take the $200 million in five years.
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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 32 percent this year and 37 percent next year and that he can earn an after-tax rate of return of 12 percent on his
investments. Should Sal send his client the bill in December or January? Use Exhibit 3.1. (Round discount factor(s) to three decimal
places.)
Send the bill in December.
Option 1: Send $40,000 bill in December:
$40,000 taxable income × 32% marginal tax rate = $12,800 in present value tax
After-tax income = Pretax income − Present value tax
= $40,000 − $12,800 = $27,200
Option 2: Send $40,000 bill in January:
$40,000 taxable income × 37% marginal tax rate = $14,800 in tax in one year.
Present value of tax = $14,800 × 0.893 (discount factor, one year, 12 percent) = $13,216
After-tax income = Pretax income − Present value tax = $40,000 − $13,216 = $26,784
Sending the $40,000 bill in December is preferred.
References


Sal, a calendar-year taxpayer, uses the cash-basis method of accounting for his sole proprietorship. In late December, he performed
$20,000 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 32 percent this year and 37 percent next year and that he can earn an after-tax rate of return of 7 percent on his
investments. Should Sal send his client the bill in December or January? Use Exhibit 3.1. (Round discount factor(s) to three decimal
places.)
Send the bill in December.
Option 1: Send $20,000 bill in December:

$20,000 taxable income × 32% marginal tax rate = $6,400 in present value tax
After-tax income = Pretax income − Present value tax
= $20,000 − $6,400 = $13,600
Option 2: Send $20,000 bill in January:

$20,000 taxable income × 37% marginal tax rate = $7,400 in tax in one year.
Present value of tax = $7,400 × 0.935 (discount factor, one year, 7 percent) = $6,919
After-tax income = Pretax income − Present value tax = $20,000 − $6,919 = $13,081
Sending the $20,000 bill in December is preferred.
References


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
percent of the income as a collection fee. Lucky will report the remaining 50 percent. Will this shift the income from Lucky to Rocco? Why
or why not? What doctrines influence your answer? Any suggestions for Lucky?
While Rocco's collection efforts are likely to warrant some fee from Lucky, a 50 percent fee is not likely to hold up to scrutiny. In particular,
because this is a related-party transaction, the IRS is likely to scrutinize whether the 50 percent is reasonable or instead if this is just a
scheme to assign Lucky's income to Rocco. Both the assignment of income and substance-over-form doctrines come into play in this
transaction. If Lucky wants to shift income to Rocco, he can employ Rocco and pay him a market (i.e., reasonable) wage. Conversely, if he
owns income-generating property, he can transfer ownership of the property to Rocco, which will result in Rocco being taxed on the
property's income in the future. The downside to this transaction is that Lucky may have serious reservations about transferring
significant wealth to his son.
References

strategy.

Bono owns and operates a sole proprietorship and has a 32 percent 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 percent. What could Bono do to reduce his family
tax burden? How much pretax 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?
Bono could reduce his family's tax burden by employing his son in his sole proprietorship, thus shifting income taxed at 32 percent
(Bono's marginal tax rate) to 15 percent (Richie's tax rate). It currently takes Bono $17,647.06 of pretax income to generate the $12,000
after taxes given to Richie.
After-tax income = Pretax income × (1 − marginal tax rate)

$12,000 = Pretax income × (1 − 0.32)
Pretax income = $12,000 / (0.68) = $17,647.06.
If Richie worked for Bono's sole proprietorship, he would only have to pay him $14,117.65 to generate $12,000 after taxes.
$12,000 = Pretax income × (1 − 0.15)
Pretax income = $12,000 / (0.85) = $14,117.65.
This strategy will save Bono $3,529.41 pretax (i.e., $17,647.06 − $14,117.65) and $2,400 after taxes ($3,529.41 × (1 − 0.32)).
References

strategy.
Bono owns and operates a sole proprietorship and has a 32 percent marginal tax rate. He provides his son, Richie, $26,000 a year for
college expenses. Richie works as a street musician and has a marginal tax rate of 15 percent. What could Bono do to reduce his family
tax burden? How much pretax income does it currently take Bono to generate the $26,000 after taxes given to Richie? If Richie worked
for his father's sole proprietorship, what salary would Bono have to pay him to generate $26,000 after taxes? (Ignore any Social Security,
Medicare, or self-employment tax issues.) How much money would this strategy save?
Bono could reduce his family's tax burden by employing his son in his sole proprietorship, thus shifting income taxed at 32 percent
(Bono's marginal tax rate) to 15 percent (Richie's tax rate). It currently takes Bono $38,235.29 of pretax income to generate the $26,000
after taxes given to Richie.

$26,000 = Pretax income × (1 − 0.32)
Pretax income = $26,000/(0.68) = $38,235.29.
If Richie worked for Bono's sole proprietorship, he would only have to pay him $30,588.24 to generate $26,000 after-taxes.
$26,000 = Pretax income × (1 − 0.15)
Pretax income = $26,000/(0.85) = $30,588.24.
This strategy will save Bono $7,647.05 pretax (i.e., $38,235.29 − $30,588.24) and $5,199.99 after tax ($7,647.05 × (1 − 0.32)).
References

strategy.
Jayzee is a single taxpayer who operates a sole proprietorship. He expects his taxable income next year to be $150,000, of which
$125,000 is attributed to his sole proprietorship. Jayzee is contemplating incorporating his sole proprietorship. Using the 2020 single
individual tax brackets and the corporate tax brackets, how much current tax could this strategy save Jayzee? (Ignore any Social Security,
Medicare, or self-employment tax issues.) How much income should be retained in the corporation? (Use tax rate schedule)
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 12 percent tax bracket. The task is to allocate the $125,000 between Jayzee and his corporation to minimize his current liability. The
corporate tax rate is 21 percent and is higher than Jayzee's marginal tax rate of 12 percent. To take advantage of the remaining $15,125 of
the 12 percent individual tax bracket ($40,125 − $25,000), $15,125 of the profits should be shifted to Jayzee. Jayzee's personal marginal
tax rate would now be 22 percent, and his corporation's marginal tax rate of 21 percent is now lower. To minimize this year's taxes, the
remaining $109,875 of corporate profits should be retained in the corporation and taxed at 21 percent. In sum, $109,875 of the expected
profits are retained in the corporation and $15,125 of the profits are shifted to Jayzee.
This strategy will save Jayzee $2,388.25, calculated as:
(a) The tax on $150,000 of taxable income reported by Jayzee, assuming that he operates his business as a sole proprietorship $ 30,079.50
Less:
(b) The tax on $40,125 of taxable income reported by Jayzee, assuming that he incorporates his business −$ 4,617.50
(c) The tax on $109,875 profits retained in the corporation −$ 23,073.75
Total =$ 2,388.25
References

strategy.
Bobby and Whitney are husband and wife, and Whitney operates a sole proprietorship. They expect their joint taxable income next year
to be $225,000, of which $175,000 is attributed to the sole proprietorship. Whitney is contemplating incorporating the sole
proprietorship. Using the 2020 married filing jointly tax brackets and the corporate tax brackets, how much current tax could this strategy
save Bobby and Whitney? How much income should be retained in the corporation? (Use tax rate schedule.)
Assuming Bobby and Whitney's goal is to minimize their current federal income tax exposure, one can compare the married filing jointly
and corporate tax rate schedules to achieve this goal. Since Bobby and Whitney have $50,000 of taxable income not related to the sole
proprietorship, they are currently in the 12 percent tax bracket. The task is to allocate the $175,000 between Bobby and Whitney and the
corporation to minimize their current liability. The corporate tax rate is 21 percent and is higher than Bobby and Whitney's marginal tax
rate of 12 percent. To take advantage of the remaining $30,250 of the 12 percent individual tax bracket ($80,250 − $50,000), $30,250 of
the profits should be shifted to Bobby and Whitney. Bobby and Whitney’s personal marginal tax rate would now be 22 percent, which is
higher than the corporation's tax rate of 21 percent. To take advantage of the corporation's 21 percent tax bracket, the remaining
$144,750 of corporate income should be retained in the corporation. In sum, $144,750 of the expected profits are retained in the
corporation and $30,250 of the profits are shifted to Bobby and Whitney.
This strategy will save Bobby and Whitney $2,526.50, calculated as:
(a) The tax on $225,000 of taxable income reported by Bobby and Whitney, assuming that Whitney operates her
business as a sole proprietorship $ 42,159.00
Less:
(b) The tax on $80,250 of taxable income reported by Bobby and Whitney, assuming that they incorporate the business −$ 9,235.00
(c) The tax on $144,750 profits retained in the corporation −$ 30,397.50
Total =$ 2,526.50
References

strategy.
Rob is currently considering investing in municipal bonds that earn 4 percent interest or taxable bonds issued by Dell Computer that pay
6.5 percent. If Rob's tax rate is 20 percent, which bond should he choose? Which bond should he choose if his tax rate is 30 percent? At
what tax rate would he be indifferent to the municipal bond or to the corporate bond? What strategy is this decision based upon?
Rob's after-tax rate of return on the tax-exempt bond is 4 percent (i.e., the same as its pretax rate of return). The Dell Computer bond
pays taxable interest of 6.50 percent. Rob's after-tax rate of return on the Dell Computer bond is 5.20 percent (i.e., 6.50 percent interest
income − (6.50% × 20%) tax = 5.20%). Rob should invest in the Dell Computer bond.
If Rob's marginal tax rate is 30 percent, his after-tax rate of return on the Dell Computer bond would be 4.55 percent (i.e., 6.50% interest
income − (6.50% × 30%) tax = 4.55%). Rob should invest in the Dell Computer bond in this situation.
Rob would be indifferent between the two bonds if his marginal tax rate is 38.46 percent.
After-tax return = Pretax return × (1 − marginal tax rate)
4% = 6.50% × (1 − marginal tax rate) = 6.50% − (6.50% × marginal tax rate)
6.50% marginal tax rate = 2.50%
Marginal tax rate = 2.50%/6.50% = 38.46%
This example is an illustration of the conversion planning strategy.
References
Maurice is currently considering investing in a high dividend yield stock with no growth potential that pays a 6 percent dividend yield or
bonds issued by the Coca-Cola Company that pay 8 percent. If Maurice's ordinary tax rate is 25 percent and his dividend tax rate is 15
percent, which investment should he choose? Which investment should he choose if his ordinary tax rate is 30 percent? At what ordinary
tax rate would he be indifferent between the stock and the bond? What strategy is this decision based upon?
Maurice's after-tax rate of return on the dividend-paying stock is 5.10 percent (i.e., 6% × (1 − 0.15)). The Coca-Cola Company bond pays
taxable interest of 8 percent. Maurice's after-tax rate of return on the Coca-Cola Company bond is 6 percent (i.e., 8% interest income −
(8% × 25%) tax = 6%). Maurice should invest in the Coca-Cola Company bond.
If Maurice's marginal tax rate is 30 percent, his after-tax rate of return on the Coca-Cola Company bond would be 5.60 percent (i.e., 8%
interest income − (8% × 30%) tax = 5.60%). Maurice should still invest in the Coca-Cola bond in this situation.
Maurice would be indifferent between the two investments if his ordinary tax rate is 36.25 percent.
After-tax return = Pretax return × (1 − marginal tax rate)
5.10% = 8% × (1 − marginal tax rate) = 8% − (8% × marginal tax rate)
8% marginal tax rate = 2.90%
Marginal tax rate = 2.90%/8% = 36.25%
This example is an illustration of the conversion planning strategy.
References
Susan Brown has decided that she would like to go back to school after her kids leave home in five years. To save for her education,
Susan would like to invest $25,000 in an investment that provides a high return. If her marginal tax rate is 35 percent, what is Susan's
after-tax rate of return for the following investment options? Qualified dividends are taxed at 15 percent.
(1) Corporate bond issued at face value with 10 percent stated interest rate payable annually.
(2) Dividend-paying stock with an annual qualifying dividend equal to 10 percent of her investment.
(3) Growth stock with an annual growth rate of 8 percent and no dividends paid. (Round your interim calculations to the nearest whole
number.)
(1) Corporate bond

0.10 × (1 − 0.35) = 6.50%
(2) Dividend-paying stock

0.10 × (1 − 0.15) = 8.50%
(3) Growth stock

$25,000 × (1 + 0.08)5 = $36,733
$36,733 − $25,000 = $11,733
$11,733 × 0.15 = $1,760
$36,733 − $1,760 = $34,973
[($34,973 / $25,000)1/5 − 1] = 6.94%
References
Essay Difficulty: 2 Medium Learning Objective: 03-05 Apply the conversion strategy.
Susan Brown has decided that she would like to go back to school after her kids leave home in five years. To save for her education,
Susan would like to invest $31,000 in an investment that provides a high return. If her marginal tax rate is 35 percent, what is Susan's
after-tax rate of return for the following investment options? Qualified dividends are taxed at 15 percent.
(1) Corporate bond issued at face value with 21 percent stated interest rate payable annually.
(2) Dividend-paying stock with an annual qualifying dividend equal to 8 percent of her investment.
(3) Growth stock with an annual growth rate of 9.4 percent and no dividends paid. (Round your intermediate calculations to the nearest
whole number.)
(1) Corporate bond

0.21 × (1 − 0.35) = 13.65%
(2) Dividend-paying stock

0.08 × (1 − 0.15) = 6.8%
(3) Growth stock

$31,000 × (1 + 0.094)5 = $48,579
$48,579 − $31,000 = $17,579
$17,579 × 0.15 = $2,637
$48,579 − $2,637 = $45,942
[($45,942/$31,000)1/5 − 1] = 8.19%
References
Essay Difficulty: 2 Medium Learning Objective: 03-05 Apply the conversion strategy.
Boeing is considering opening a plant in one of two neighboring states. One state has a corporate tax rate of 15 percent. If operated in
this state, the plant is expected to generate $1,200,000 pretax profit. The other state has a corporate tax rate of 5 percent. If operated in
this state, the plant is expected to generate $1,085,000 of pretax profit. Which state should Boeing choose based upon tax
considerations only? Why do you think the plant in the state with a lower tax rate would produce a lower pretax income?
Boeing should choose to operate the plant in the state with the 5 percent tax rate. Operating the plant in this state would generate
$1,030,750 of profits after state taxes (i.e., $1,085,000 − (5% × $1,085,000) = $1,030,750) versus $1,020,000 of profits after state taxes (i.e.,
$1,200,000 − (15% × $1,200,000) = $1,020,000) if Boeing operated in the state with the 15 percent rate.
The state with a lower tax rate produces a lower pretax income because the demand for workers, services, property, etc. in the low tax
rate state jurisdiction has most likely increased the costs associated with operating a business in this state. These increased costs are
considered implicit taxes and reduce the tax advantages of operating in the low tax rate state.
References

strategy.

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1. Award: 1.

The goal of tax planning is tax minimization.

2. Award: 1.00 point

Nontax factors do not play an important role in tax planning.

3. Award: 1.00 point

5. Award: 1.00 point

In general, tax planners prefer to accelerate deductions.

6. Award: 1.00 point

The concept of present value is an important part of the timing strategy.

True / False Learning Objective: 03-02

Diﬃculty: 1 Easy Learning Objective: 03-03

1 / (1 + 0.10) = 0.909 PV. $100 × 0.909 = $90.90 versus $85.

8. Award: 1.00 point

9. Award: 1.00 point

Future value can be computed as Future Value = Present Value/(1 + r)n.

Future Value = Present Value × (1 + r)n

11. Award: 1.00 point

When considering cash inﬂows, higher present values are preferred.

12. Award: 1.00 point

When considering cash outﬂows, higher present values are preferred.

Tax savings generated from deductions are considered cash inﬂows.

14. Award: 1.00 point

Deferring income is an example of the timing strategy.

True / False Learning Objective: 03-02

Diﬃculty: 1 Easy Learning Objective: 03-05

15. Award: 1.00 point

The timing strategy is particularly effective for cash-basis taxpayers.

The timing strategy becomes more attractive as tax rates decrease.

17. Award: 1.00 point

18. Award: 1.00 point

19. Award: 1.00 point

True / False Learning Objective: 03-05

Diﬃculty: 2 Medium Learning Objective: 03-06

21. Award: 1.00 point

The constructive receipt doctrine is more of an issue for cash-basis taxpayers.

True / False Learning Objective: 03-02

Diﬃculty: 2 Medium Learning Objective: 03-06

22. Award: 1.00 point

24. Award: 1.00 point

25. Award: 1.00 point

True / False Learning Objective: 03-02

Diﬃculty: 1 Easy Learning Objective: 03-04

The income-shifting strategy requires taxpayers with varying tax rates.

27. Award: 1.00 point

The assignment of income doctrine is a natural limitation to the timing strategy.

True / False Learning Objective: 03-02

Diﬃculty: 2 Medium Learning Objective: 03-06

28. Award: 1.00 point

True / False Learning Objective: 03-04

Diﬃculty: 2 Medium Learning Objective: 03-06

30. Award: 1.00 point

31. Award: 1.00 point

32. Award: 1.00 point

Implicit taxes may reduce the beneﬁts of the conversion strategy.

Investors must consider implicit as well as explicit taxes.

34. Award: 1.00 point

True / False Learning Objective: 03-05

Diﬃculty: 2 Medium Learning Objective: 03-06

35. Award: 1.00 point

Tax avoidance is legal; tax evasion is not.

37. Award: 1.00 point

38. Award: 1.00 point

The goal of tax planning generally is to: