JOHN E. KARAYAN, JD, PHD, is a professor at California State Polytechnic University, Pomona. He is also a Partner at the law firm of Bond Karayan. Prior to his academic career, he was director of taxes at Informatics General Corporation (now Sterling Software); assistant tax counsel at The Parsons Corporations, and supervising specialist at Coopers & Lybrand (now PricewaterhouseCoopers). He is the Editor in Chief of the Journal of Interdisciplinary Studies as well as a member of the editorial review board (former associate editor) of Mid-Atlantic Journal of Business, Research in Healthcare Financial Management, and the Business Forum Journal.

CHARLES W. SWENSON, CPA, PHD, is Professor and Leventhal Research Fellow in the Marshall School of Business at the University of Southern California, where he has taught for the last nineteen years. He holds a joint appointment at the California Institute of Technology (Caltech). His practice experience includes PricewaterhouseCoopers and Deloitte & Touche. He is a member of the AICPA and the American Economics Association, and is a cofounder of the National Tax Credit Group, LLC.

Strategic Business Tax Planning 2nd Edition

By John E. Karayan Charles W. Swenson

John Wiley & Sons

Copyright © 2006 John E. Karayan
All right reserved.
ISBN: 978-0-470-00990-1

Chapter One

A Framework for Understanding Taxes

The claim that information would define the future reminded me of the famous party scene in the 1967 movie The Graduate. A businessman buttonholes Benjamin, the college graduate played by Dustin Hoffman, and offers him a single word of unsolicited career advice: “plastics.” I wondered whether, if the scene had been written a few decades later, the businessman’s advice would have been: “One word, Benjamin: ‘information.'” -Bill Gates, The Road Ahead

How much do taxes touch us? Think about what people do every day. Buy a cup of coffee, and some sort of sales tax is almost always in what you pay. Make a telephone call, and most likely there is an excise tax. Earn wages, and a significant portion usually must be withheld for payroll taxes. Make money trading stocks over the Web, and a large percentage of the profits likely will be lost to income taxes.

As this thought experiment suggests, taxes are everywhere, embedded in every transaction. To check this, run a Web search on the word taxes. Consider the sheer number of hits generated. Then run the search again on the Web site of a national newspaper (such as www.nytimes.com or www.economist.com). How many articles discuss taxes? Finally, explore one of the gateway Web sites in taxation, such as www.taxsites.com or www.taxworld.org. (As you may already know, a gateway is site that consists primarily of links to other Web sites. Gateways are particularly handy for keeping track of the constant changes in Web addresses and for finding new sites.)

Be sure to look at the Web site for the U.S. Internal Revenue Service (IRS), www.irs.gov. This was one of the first major sites for a governmental agency and is one of the most heavily used. Browse the various publications available there. How many are there? Look for tax calculators, such as www.denvertax.com, and free tax return preparation sites, such as those found at www.taxsites.com/software .html. Finally, take a look at tax policy sites, such as the one devoted to the history of taxation found at www.uic.edu/depts/lib/ collections/govdocs/tax/taxhistory.html, or the “Hot Topics in Taxation” page of the University of Michigan’s Office of Tax Policy Research atwww.bus.umich.edu/OTPR/whatotpr.htm. A list of similar sites can be found atwww.taxsites.com/academia.html.

One reason that taxes seem to be everywhere is that they are a price paid for government. Not the total price: To some extent (and in many ways, both directly and indirectly), governments support themselves by charging users for specific services provided. For example, some local governments charge a monthly fee to owners of residences that are hooked up to municipal sewer systems. However, governments are primarily financed through taxation.

Taxes are charges not directly related to goods or services provided by a government that are imposed on people and organizations located within a government’s legal reach. In many locations, a multitude of governments and their subdivisions-ranging from cities to nations, school districts to metropolitan rapid transit districts-levy a myriad of taxes on a wide variety of activities, such as income taxes on business profits, property taxes on wealth, value-adding taxes on purchases, and payroll taxes on compensation.

Some taxes are periodic. For example, payroll taxes on employees are usually withheld from each paycheck, and income taxes are typically based on one year’s earnings. Other taxes are generated if, and only if, certain transactions occur. For example, sales taxes are usually triggered by the retail sales of goods, and inheritance taxes may arise when title to property is passed to a person’s heirs. (For more information on these and other topics, check Web sites, such as www.taxsites.com. For current details, such tax rate schedules, try the tax authority’s Web site. If U.S. federal taxes are of interest, go to www.irs.gov, click on “Forms and Publications,” click on “Search for a Form or Publications,” and input the term in which you are interested into the search engine.)

The primary purpose of most taxes is to raise revenue to finance governments. But because taxes impose costs on transactions, taxes affect human behavior, and thus can be (and are) used by governments to try to shape society. Indeed, the primary purpose of some taxes-such as excise taxes on the sale of machine guns, tobacco, and pollutants-is to further social engineering goals.

Taxes seem to be everywhere, and are triggered by a bewildering array of activities. Taxes also impose significant costs, which can be reduced by changing one’s behavior. Thus, planning for taxes can be important in making good financial decisions.

HOW ARE TAXES IMPORTANT IN DECISION MAKING?

Sometimes taxation, and thus tax planning, is one of the most important factors in decision making. Consider the following scenario. Your best friend, who lives in New York City, e-mails you with the news that she has just inherited a large amount of cash. She asks for your help in investing it in mutual funds, which primarily hold bonds. Look in a financial newspaper or Web site that shows the current earnings of various bond funds. Pick five at random, and calculate their average yield. Now do the same for five that have the words “tax exempt” or “municipal” in their names. (For the uninitiated, this means that these funds invest primarily in bonds issued by U.S. states and local government agencies. Interest paid on such securities typically is exempt from U.S. income tax and can be exempt from state income taxes, as well.) What is the difference in the average yields of the first set of mutual funds and those that are tax exempt? Could a significant part of this difference be accounted for by tax effects?

Tax planning can affect decision making in even the most commonplace of settings. Consider the case of a typical homeowner whose annual property tax payment must be paid before January of the following year. Income tax typically is tax based on net income-that is, taxable revenues less their tax-deductible expenses-for each calendar year. Assume that the property tax is a deductible expense and that the homeowner’s marginal tax rate is 28%. (This means that every dollar of additional income results in $.28 in additional tax. Similarly, every dollar of tax-deductible expense saves $.28 in taxes.)

If homeowners pay the property tax in December, they will get a tax deduction for the current year. The tax benefit is delayed a year, however, if they wait until January to pay. Thus, simply paying this deductible expense a few days earlier can generate tax savings a year earlier. This simple bit of planning results in tax benefits through timing, an important component of strategic tax planning. (For an excellent, albeit conservative, overview of the U.S. income tax on individuals, download the current version of the IRS’s Publication 17, Your Federal Income Tax, from the IRS Web site at www.irs.gov. Included are the current tax rate schedules, personal and dependency exemption amounts, various thresholds for the phase-out of a variety of tax benefits for higher-income taxpayers, and the amounts for standard deductions. All of these, and many other details, change annually. Many specific amounts are indexed annually for inflation. They also may be changed, for various reasons, by tax legislation. Also included in Publication 17 are good cross references to more detailed publications on other tax topics. These range from Publication 334, Tax Guide for Small Business, to Publication 542, Corporations.

Tax planning often represents a significant part of doing business. In some cases, taxes are one of the most important aspects in structuring a transaction. Consider Tax Management in Action 1.1.

This case study illustrates just how important taxes can be in a business transaction. DuPont was able to capture part of Seagram’s tax savings by negotiating a lower price for the stock it bought back, and Seagram was able to transform what would have been a taxable transaction (had the DuPont stock been sold on the open market) into a largely tax-free transaction by using the tax law. Moreover, the transaction was motivated by strategic plans of both firms: Seagram, for example, wanted to acquire MCA for strategic business reasons. The decision to sell the stock was motivated by the strategic decision to purchase MCA; only the form-a stock redemption by DuPont of its own shares-was motivated by tax savings. This example shows how good tax planning can add significant value to a transaction. Although transactions typically do not have such dramatic tax effects, the example illustrates how a transaction can have an important tax component.

Taxes are only one of the many factors that people and organizations consider when making decisions. In some cases, taxes are a dominant factor; in others, tax considerations play a minor part. Good decision makers generally seek to manage taxes on every major transaction. One way to measure how well a firm is managing its taxes is to look at its effective income tax rate. A firm’s effective tax rate is the sum of taxes paid by the firm, divided by its (before-tax) net income. Often effective tax rates of firms exceed 40%. This is not surprising for multinational firms operating in the United States, because they usually are subject to 35% rate on U.S. income plus an assortment of international, national, and local taxes.

As shown in Tax Management in Action 1.2, even large firms can have widely varying effective tax rates. In the example, however, all have rates well below 40%, which shows that these firms are managing their taxes.

These companies were able to reduce their tax burdens to rates below the benchmark 40% primarily by locating operations so that large proportions of taxable income were derived from locations with tax rates lower than the 35% federal rate typical for operations in the United States. To put some perspective on this, take a closer look at Johnson & Johnson. By bringing its effective tax rate down to 23%, it saved $270 million in taxes. These tax savings were due to a large proportion of its taxable income being derived from Puerto Rico, which allowed the company to enjoy the U.S. possession’s tax credit. Locating operations in low-tax locations uses the strategic tax planning mechanism of transforming, which is discussed throughout this book (and in detail in Chapters 7 and 8).

TYPES OF TAXES

As already suggested, government regulation can be an important factor in economic decision making. This book is intended to help people learn how to better factor the impact of regulation into decision making by studying the effect of one prominent kind of regulation: taxation. Throughout the world, various levels of government impose an array of taxes in order to raise revenue or shape the behavior of people and organizations. This fact is illustrated by an overview of taxes in one of the world’s most important economies, the United States. Although the United States has one of the most complex systems of taxation, it also has one of the most explicit and documented tax systems in the world. For these reasons, most of the examples in this book are drawn from the United States and from its most important tax, the national income tax.

U.S. Federal Taxes

The U.S. government raises the vast majority of its revenues through taxes. (Statistics showing amounts and trends by type of tax can be found on the Web sites www.taxworld.org and www.taxsites.com, and the IRS site, www.irs.gov.) The major types are corporate and personal income taxes, payroll taxes, estate and gift taxes, excise taxes (e.g., on tobacco, alcohol, and air travel), and import duties. Because collections of excise taxes and duties are fairly small and straightforward, they are not elaborated on further in this book. (For a discussion of the relative importance of different types of taxes-both in the United States and the rest of the world- explore the Web sites reached by clicking on “policy reform” in sites like www.taxsites.com and the University of Michigan’s Office of Tax Policy Research at www.bus.umich.edu/OTPR/whatotpr.htm.) For similar reasons, the discussion on U.S. taxes will begin with estate and gift taxes.

Estate and Gift Taxes

Gift taxes are imposed when one person transfers property to another due to nonbusiness motives, such as affection and appreciation. In particular, the gift tax is imposed on individuals who transfer property in a bona fide gift. A bona fide gift has a donative intent, with no strings attached to the recipient. That is, it is not a disguised sale or form of compensation. Estate taxes are imposed on a person’s last gift: the transfer of property to heirs at one’s death. In this sense, these two complementary taxes are really one unified tax on gifts people give either while they are alive or when they die. (There is another related tax: the generation-skipping transfer tax. Because it is extraordinarily complex and rarely triggered, it is not discussed further.)

These taxes are imposed on the transferors of property, not on the recipients, and are based on the fair market value of the property transferred. In addition, both use the same tax rates. (For more information, see www.taxsites.com or go to the IRS Web site and see IRS Publication 950, Introduction to Estate and Gift Taxes. When you get to the IRS Web site, click on “Forms and Publications,” click on “Search for a Form or Publications,” and input the term “gift tax” into the search engine.)

The intent of these taxes is not so much to raise revenue as to try to prevent excessive concentrations of hereditary wealth. In doing so, they help provide additional vertical equity in the tax system beyond that provided by the income tax. That is, estate and gift taxes attempt to impose additional taxes on wealthier individuals. Both taxes are steeply progressive, which means that tax rates increase as the taxed amount increases. A 10-year phased reduction of these taxes began in 2001. Since then, the top tax rate has dropped to around 45%. In 2010, the estate tax rate is scheduled to drop to 0, while the gift tax rate drops to 35%. Both jump back to 55% in 2011 unless new legislation is passed.

These are taxes on givers: There are no U.S. taxes on the recipients of bona fide gifts or inheritances (although some U.S. states do impose such taxes). In addition, recipients do not pay income taxes on gifts or inheritances, nor are income taxes imposed on givers when appreciated property is transferred.

There are numerous exceptions to these taxes, making actual payments fairly rare. The most important exemptions are for transfers of property between spouses (both during marriage and upon divorce) and most donations to public institutions, such as charities, universities, and churches (which also are exempt from income tax). In addition, small gifts are not taxed. For example, there is an annual exclusion amount of $11,000 per year per donor per donee. (This amount, too, is indexed for inflation.) If the donor is married, the gift can be treated as if it came from both spouses, in which case the annual exclusion doubles. The annual exclusion is a simple tax-planning method that can be used to avoid taxes when large gifts are given in installments. (See Example 1.1.)

Like the U.S. income tax, U.S. gift taxes are calculated and paid annually. Unlike the income tax, the gift tax is a lifetime tax, which is figured by including in the amount subject to gift tax for a year-the gift tax base-both the taxable gifts made during the year and all taxable gifts made in prior years (but only those since 1976, when the current unified system was enacted). However, prior gifts are not double-taxed. This is because a credit for the tax on prior gifts is allowed against the current year’s tax. That is, every dollar of taxes on gifts made in prior years offsets a dollar of taxes calculated for the current year. Because of the progressive rate structure, this results in increasingly higher rates in each successive year until the top bracket is reached.

(Continues…)

Excerpted from Strategic Business Tax Planning 2nd Editionby John E. Karayan Charles W. Swenson Copyright © 2006 by John E. Karayan. Excerpted by permission.
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