Exam 3: Tax Planning Strategies and Related Limitations

Bono owns and operates a sole proprietorship and has a 32 percent marginal tax rate. He provides his son, Richie, $11,000 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 $11,000 after taxes given to Richie? If Richie worked for his father's sole proprietorship, what salary would Bono have to pay him to generate $11,000 after taxes? (Ignore any Social Security, Medicare, or self-employment tax issues.)How much money would this strategy save?

Assuming a positive interest rate, the present value of money suggests:

The constructive receipt doctrine is a natural limitation for the conversion strategy.

Tax savings generated from deductions are considered cash inflows.

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 6.8 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?

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?

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

Paying dividends to shareholders is one effective way of shifting income from a corporation to its shareholders.

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.

Effective tax planning requires all of these considerations except:

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?

Investing in municipal bonds to avoid paying tax on interest earned and to earn a higher after-tax yield is an example of:

When considering cash outflows, higher present values are preferred.

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?

Paying "fabricated" expenses in high tax rate years is an example of:

Joe Harry, a cash-basis taxpayer, owes $18,000 in tax-deductible accounting fees for his business. Assume that it is December 28^th and that Joe Harry can avoid any finance charges if he pays the accounting fees by January 10^th. 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 6 percent. When should Joe Harry pay the $18,000 fees and why? Use Exhibit 3.1. (Round discount factor(s)to three decimal places.)

The timing strategy is based on the idea that the location of where the income is taxed affects the tax costs of the income.

If tax rates are decreasing:

Assume that Juanita is indifferent between investing in a corporate bond that pays 8.20 percent interest and a stock with no growth potential that pays a 6.20 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.)

If tax rates are increasing: