LEARNING OBJECTIVES After studying this chapter, you should be able to D> Apply the investment models to various investment alternatives P> Use the investment models to make entity choices D> Use the investment models to make current salary versus deferred compensation decisions D> Understand the role of implicit taxes in investment decisions TAXES AND INVESTMENT PLANNING | =m”). oom (YY18-2 Individuals ¥ Chapter 18 CHAPTER OUTLINE This chapter has been derived from a book originally written by Myron S. Scholes and Investment Models.182 Mark A. Wolfson and takes what has become known as the Scholes-Wolfson approach to Other Application of investment investment strategy.! Consequently, the chapter differs significantly from other chapters Models1815 in this text. First, the chapter does not present details of tax law: Instead, it introduces a een conceptual framework for understanding how taxes affect basic investment decisions. Second, the chapter develops and illustrates models for determining the after-tax out- comes of various investment alternatives. Although these models may look strange at first, they become familiar and manageable after some study and practice. Third, the chapter extends the models’ application to the flow-through versus C corporation choice and the current salary versus deferred compensation decision. Fourth, the chapter intro- ‘duces the role of implicit taxes as well as explicit taxes in investment decisions. As demon- strated later, the before-tax rate of return of a tax-favored asset will be reduced by market forces as investors increase their demand for these investments. This reduced rate of return isan implicit tax that investors need to consider when making their decisions. (NANvestMENT MODELS FI Te investment models described in this chapter fall into four categories depending on how investment earnings are taxed. We refer to these models as follows OBJECT Apply the investment > The Current Model—Investment earnings are taxed currently. models to various _ > The Deferred Model—Investment earnings are taxed at the end of the investment investment alternatives period. > The Exempt Model—Investment earnings are exempt from explicit taxation, » The Pension Model—The initial investment is deductible or excludable from gross income, and investment earnings are taxed at the end of the investment period. KEY POINT ‘These models in their basic form reflect the following assumptions: Future aus are necessay te, > The investment’ before-tax rate of return is constant over the investment period. poldtin time. Ths comparable” The investor's marginal tax rate is constant over the investment period. Alternative investment oppor” Investment earnings are reinvested at the same rate of return as earned by the original ‘unites. investment. > The investor knows future rates of returns and tax rates with certainty > The investor incurs no transaction costs. The models can be modified, however, to accommodate changes to these assumptions. For example, we later show how to adapt the Current Model for changing tax rates (see Example [:18-5). ADDITIONAL For simplicity, this chapter generally uses the following individual marginal tax rates COMMENT for ordinary income: 40%, 35%, 30%, 25%, and 15%, Although these rates do not con- Although we use 5%, the capital form exactly to current tax rates, they are sufficient to demonstrate the concepts in this eats tor axpavers like chapter. In addition, the chapter assumes either a 15% or 5% capital gains tax rate for zero in 2008-2010 transactions not subject to the Sec. 1202 exclusion. For regular C corporations, the chap- ter uses the following marginal tax rates: 39%, 35%, 34%, 25%, and 15%. THE CURRENT MODEL ‘The Current Model gives the future value of an investment having the following charac- teristics: > Only after-tax dollars are invested. > The earnings on the investment are taxed annually (currently); thus, the reinvested earnings grow at the after-tax rate of return, ML 5. Scholes, M. A. Wolfson, M. Erickson, EL. Maydew, and. Shevlin, Taxes and Business Strategy A Planning Approach, Thied Edition (Uppet Sadle River, NJ Pearson Prentice Hall, 2005).EXAMPLE [:18-1 > EXAMPLE 1:18-2 TAX STRATEGY TIP ‘Although this chapter focuses on federal income taxes, a taxpayer ‘must consider all applicable taxes when making investment decisions, ‘Taxes and Investment Planning ¥ Individuals 18-3 Common examples of investments taxed this way are savings accounts, money market funds, and taxable bonds, ifthe investor reinvests the after-tax earnings annually. INVESTMENT WITH NO TAXATION. Before developing the Current Model, how- ever, we first illustrate how an investment grows when compounded annually in a no-tax situation, and we introduce the notions of before-tax dollars and the before-tax rate of return, We then show the relationship between before-tax dollars and after-tax dollars and between before-tax and after-tax rates of return. Finally, we incorporate these con- cepts into the Current Model. Carla, an individual investor, lives in a land of no taxation and earns $1,000 of salary. She invests this amount in a bond that pays interest at 10% per year and holds the bond for three years, reinvesting the interest annually at the same 10% return. The following schedule details the investment’s cash flow over the three years: o @) 3 @ ‘Cumufatve Investment Interest ‘Cumulative Investment Year ‘at Beginning of Year Income? at End of Yeare 1 $1,000 $100 $1,100 2 1,100 110 11210 3 1210 121 1331 Column 2 x 109% Column 2 + Colum 3 Thus, at the end of three years, the $1,000 original investment accumulates to $1,331. The three-year accumulation determined in Example :18-1 also can be calculated as follows: $1,000 (1.1)? = $1,331, which is $1,000 compounded at 10% for three years. Thus, the general form of the compounding formula is: Accumulation = BTS(1 + R)* In this formula, BTS stands for before-tax dollars invested. For instance, in Example 1:18-1, Carla invested the entire $1,000 because taxes did not reduce her salary. Also in the formula, R is the before-tax rate of return (BTROR). Again, this return isa before-tax per- centage because, as in Example 1:18-1, the interest on the investment is not taxed. Consequently, the investor can reinvest all the interest with nothing siphoned away as taxes. Finally, n equals the number of years the investor holds the investment or, in other ‘words, n represents the investment horizon. Thus, the formula gives the future value (accu- mulation) of before-tax dollars invested for n years while earning a BTROR equal to R. THE CURRENT MODEL. Now assume our investor is subject to taxation at marginal tax rate t. In this case, any earned income, such as salary, will be subject to taxes, leaving only after-tax dollars available for investment. ‘Assume the same facts as Example I:18-1 except Carla's $1,000 salary is subject to tax, and her ‘marginal tax rate is 40%. That i, t = 40% or 0.4 In this case, Carla has only $600 to invest. This ‘amount is computed as follows: Salary before taxes $1,000 Minus: Taxes ($1,000 x 0.4) (400) After-tax dollars available to invest. $600 < ‘The $600 amount determined in Example I:18-2 also can be calculated as follows: After-tax dollars = $1,000 ~ ($1,000 x 0.4) $1,000 (1 ~ 0.4) (Factoring out the $1,000 salary) = $1,000 x 0.6 = $600