UVA-C-2185

Rev. Aug. 18, 2016

A Guide to Taxation and Management Decisions1

This guide provides an overview of tax planning, tax systems, and some basic elements of U.S. tax law.2

Framework for Effective Tax Planning

Effective tax planning considers:

All taxes

Examples:
Explicit taxes: paid directly to the government.
Implicit taxes: lower before-tax, risk-adjusted returns earned by tax-favored assets.

All parties

Examples:
Compensation (employer and employee)
Venture capital (entrepreneur and venture capitalist)

All costs

Examples:
Financial reporting costs
Political costs

All taxes

When most people think of taxes, they think of explicit taxes: the direct taxes paid (tax benefits received)
explicitly to (from) various governments. Implicit taxes often go unnoticed, but they are as much of a cost as
explicit taxes.

1 The author thanks Merle Erickson, Greg Geisler, Ed Maydew, Sonja Rego, Richard Sansing, and Doug Shackelford for either discussions or notes

that contributed to this note.

2 Taxes and Business Strategy: A Planning Approach discusses some of these topics in sections: 1.2, 2.1, 2.2, 2.3, 5.2, 5.3, 5.4, 6.5, 7.1, 7.3, and 7.4.

This technical note was prepared by Assistant Professor Mary Margaret Frank. It is a supplement to Taxes and Business Strategy: A Planning Approach by
Myron Scholes, Mark Wolfson, Merle Erickson, Ed Maydew, and Terry Shevlin, and focuses on some central concepts for class discussion. Copyright
2004 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by
any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.
Page 2 UVA-C-2185

What are implicit taxes?

Implicit taxes are the lower before-tax returns earned by tax-favored assets relative to the before-tax returns earned
by fully taxable assets of the same risk. For example, assume taxable investors have the choice between two assets
with the same risk: (1) a fully taxable asset (e.g., an A-rated corporate bond with interest taxed at 40%); and (2)
a tax-favored asset (e.g., a municipal bond with interest taxed at 0%). If the bonds have the same risk, their
expected before-tax rate of returns are initially the same (R = 10%). Taxable investors will demand more tax-
favored municipal bonds because their 10% after-tax return is higher than the 6% after-tax return on the tax-
disfavored corporate bond [10% (1 40%)]. The increase in demand bids up the price of the tax-favored
asset, which drives down its before-tax return. These taxable investors will continue to demand more of the
tax-favored asset until the expected before-tax rate of return on the tax-favored asset is 6%. With a 6% before-
tax return on the tax-favored asset and a 10% before-tax return on a tax-disfavored asset, an investor with a
40% tax rate on interest from the corporate bonds is indifferent between the two asset choices.

Bottom line: Different assets are taxed differently, and the same assets are taxed differently across taxpayers.
These differences in taxation affect demand and thus price. Taxable investors are willing to pay more (i.e., earn
a lower before-tax return) for tax-favored assets relative to tax-disfavored assets until their expected after-tax,
risk-adjusted returns on the two assets are the same.

Calculating implicit taxes and implicit tax rates

In theory, it is easy to calculate implicit taxes:

Before-tax, risk-adjusted return on fully taxable asset (corporate bond) 10%
Before-tax, risk-adjusted return on tax-favored asset (municipal bonds) 6%
Implicit tax on a tax-favored asset (municipal bonds) 4%

The implicit tax rate on a tax-favored asset is the rate that leaves the after-tax return on the fully taxable
asset equal to the before-tax return on a tax-favored asset.

Rfully (1 timplicit) = Rfavored

Example: 10% (1 40%) = 6%, so timplicit = 40%

Therefore, in the previous example the explicit tax rate on corporate (municipal) bonds = 40% (0%), and the
implicit tax rate on corporate (municipal) bonds = 0% (40%).

tEXPLICIT tIMPLICIT tTOTAL

Corporate bonds 40% 0% 40%
Municipal bonds 0% 40% 40%

Bottom line: Total taxes (explicit + implicit taxes) are the same (40%) for both assets in this example.

In reality, calculating implicit taxes and implicit tax rates becomes exceptionally difficult because we make
assumptions in theory that are hard to control in reality. In theory, we assume that: (1) the assets have the same
risk; (2) market frictions do not prevent investors from transacting, so prices fully adjust; and (3) investors are
taxable.
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Risk differences mask the impact of implicit taxes. For example, an investor has a choice between a tax-
favored stock with an expected before-tax return of 15% and a fully taxable corporate bond with an expected
before-tax return of 10%. These before-tax returns do not fit our description of implicit taxes. The tax-favored
asset (stock) that should have a lower before-tax return (i.e., implicit taxes) than the tax-disfavored asset
(corporate bond) actually has a higher before-tax return. Assuming the stock is the riskier asset, we know from
finance that higher risk leads to higher expected before-tax returns. Therefore, the before-tax return of the
stock contains two effects: (1) an increase from a risk premium; and (2) a decrease from implicit taxes. To
isolate the effect of implicit taxes, one must adjust the before-tax returns of the assets for the difference in risk.
That is why, the example above compares before-tax, risk-adjusted returns.

Market frictions (i.e., other nontax costs such as transaction costs) can keep taxable investors from acting on
their demand for tax-favored assets. If market frictions completely prevent investors from acting on their tax
preferences, then prices cannot adjust, and implicit taxes will not arise. Yet market frictions could partially
impede investors ability to maximize their tax preferences, which would give rise to implicit taxes on the tax-
favored assets, but the implicit taxes will be smaller than if the market frictions did not exist.

Taxable investors create the demand for the tax-favored asset (e.g., municipal bonds), which gives rise to the
lower before-tax, risk-adjusted return (6%). If the investors are tax-exempt then they will be indifferent between
the original 10% before-tax, risk-adjusted returns to the corporate and municipal bonds. Therefore, demand
would not change, prices would not change, and implicit taxes would not arise.

While it is difficult to calculate implicit taxes in reality, it is important to be aware of the possibility of
implicit taxes. For example, the press focuses on explicit taxes. You might see a statement in the press that
claims high-income individuals do not pay their share of taxes. If a high-income individual with a tax rate of
50% chooses to invest in only municipal bonds because municipal bonds pay 6%, and corporate bonds pay 5%
[10% (1 50%)] after-taxes, has the individual paid her share of taxes? She has paid 40% in implicit taxes by
choosing an asset with a lower before-tax, risk-adjusted return.

So, in the previous example, what investors are the marginal investors (i.e., investors who are indifferent
between the municipal bond paying 6% and corporate bond paying 10%)?

Answer: Investors with a marginal tax rate of 40%.

What investors are the inframarginal investors (i.e., investors who prefer one asset to another)?

Answer: Everybody else.

Do all inframarginal investors prefer the same asset (municipal or corporate bonds)?

Answer: No. Investors with tax rates below (above) 40% will prefer corporate (municipal) bonds because
their after-tax returns are higher. These differences give rise to tax clienteles. That is, taxpayers sort into groups
based on their tax status.

All parties

From the discussion of implicit taxes and tax clienteles, you can see that tax consequences differ across
various parties involved in a transaction. Through tax planning, transactions between parties with different tax
consequences can give rise to opportunities to increase the value of a deal for all parties or for one party leaving
all other parties equally well off.
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For example, an employer may be able to arrange a deferred compensation package for an employee that
is more beneficial to the employer than a salary compensation package, and the employee is indifferent between
deferred compensation and salary. It also could be the case that both the employer and employee are better off
with the deferred compensation contract.

Bottom line: You need to be aware of the tax consequences to all the parties involved in the transaction. You
need to have a multilateral perspective.

For any decision, it is beneficial to determine the optimal contract from a tax perspective. One approach
is to:

1. Determine one partys indifference point between two options; and

2. Determine which option the other party prefers.

All costs

Taxes are only one cost in implementing a business plan. When engaging in a strategy that saves taxes, one
must weigh the savings against other nontax costs. When engaging in a strategy that produces nontax benefits,
it is important to consider the tax costs that one might incur in implementing the strategy.

Bottom line: Taxes are one piece of the strategic puzzle.

Examples of nontax costs include:

Direct costs of tax planning paid to advisors

Political costs
Bad press
Government instability
Financial reporting costs
Deferral of income for financial accounting purposes
Uncertainty
Changes in tax law
Changes in firm profitability

The Correct Tax Rate for Tax Planning

When trying to estimate the tax savings/costs of a strategic decision, it is important to use the correct tax
rate. Theoretically, a marginal tax rate (MTR) is the present value of current and deferred taxes (explicit and
implicit) that result from an additional dollar of taxable income and is the tax rate used for decision making. It is
usually difficult to calculate implicit taxes; therefore, only explicit taxes are normally considered in the
calculation of the marginal tax rate. An average tax rate is the present value of current and deferred income taxes
paid divided by the present value of taxable income and is a measure of tax burden.
Page 5 UVA-C-2185

Example: For the first eight hours that you work in a day, you earn $50 per hour. Beyond the eighth hour,
you only earn $10 per hour.

Is your marginal wage of $10 or your average wage of $45.55 = [(8 50) + 10]/9 relevant to your decision
of whether or not work an extra hour? Your $10 marginal wage.

Tax rates work the same way. It is your marginal tax rate that should be used in making strategic decisions.

Effective tax rate appears in two contexts and is also a measure of tax burden:

1. Financial accounting: Current and deferred tax expense divided by net income before taxes.
2. Press: Current taxes paid divided by net income before taxes.

Calculation of marginal tax rates

Lets calculate the 1989 explicit marginal tax rate faced by Firm A and Firm B under the following patterns
of taxable income:

Setting: The firms began operations in 1986. In 198687 the statutory corporate tax rate was 46%. In 1988
91 the statutory corporate tax rate was 34%. Assume that the firms could project the future with certainty and
their after-tax discount rate (r) was 5%.

Firm A Income Projections

1986 1987 1988 1989 1990 1991

Statutory tax rate 46% 46% 34% 34% 34% 34%
Taxable income 100 100 100 100 100 100
Additional taxable income 1
Tax .34

To calculate the 1989 explicit marginal tax rate, we must determine the present value of the explicit tax paid
on an additional dollar of taxable income in 1989. The calculation for Firm A is straightforward. If Firm A earned
an additional $1 of taxable income in 1989 and its statutory tax rate in 1989 was 34%, it owed 0.34 in 1989 on
the $1. Therefore the present value of the tax on the $1 of taxable income earned in 1989 is 0.34, and the
marginal tax rate is 34%. Most profitable companies without NOLs that expect to be profitable in the future
have a marginal tax rate that is equivalent to the statutory tax rate similar to Firm A.

Firm B Income Projections

1986 1987 1988 1989 1990 1991>

Statutory tax rate 46% 46% 34% 34% 34% 34%
Taxable income before 1987 NOL 100 450 100 100 100 100
Additional taxable income 1
Allocation of 1987 NOL 100 N/A 100 101 100 49
Taxable income after the allocation of 1987 NOL 0 0 0 0 51
1987 NOL remaining 350 350 250 149 49 0
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For Firm B, we also determine the present value of the explicit tax paid on an additional dollar of taxable income
in 1989. The complication in this scenario is that Firm B had operating income less than operating expenses
giving rise to a net operating loss (NOL) of $450 in 1987. Under the rules in this time period, firms could carry
NOLs back to the prior three years to obtain a tax refund and carry NOLs forward for 15 years to offset future
taxable income. Therefore the NOL in 1987 affected the timing of when Firm B paid taxes on the additional
$1 of 1989 taxable income. Specifically Firm B carried back $100 of the $450 1987 NOL to 1986 and received
a refund for taxes paid in 1986. The firm still had a $350 NOL to carry forward into 1988 and beyond. Firm B
used $100 of the NOL in 1988 to reduce its taxable income to zero and carried forward a $250 NOL into 1989.
In 1989, the firm had enough NOL to offset all 1989 taxable income including the additional $1 and had a $149
NOL to carry forward into 1990. In 1990, the firm had enough NOL to offset the $100 of taxable income and
carry forward a $49 NOL. Finally in 1991, the firm only had the $49 NOL to offset its $100 of taxable income,
and the additional $1 earned in 1989 is finally taxed. The 1987 NOL deferred taxation of the additional $1 of
1989 taxable income until 1991. Thus if Firm B earned an additional $1 of taxable income in 1989 and its
statutory tax rate in 1991 was 34%, it owed .34 on the additional $1 in two years (1991). Assuming a 5% discount
rate, the present value of the tax on the $1 of 1989 taxable income is 0.308 = 0.34/(1.05)2, and the marginal tax
rate is 30.8%. Understanding the effect of NOLs and future profitability on marginal tax rates is important
because marginal tax rates affect decisions.

Decision: In 1989, should Firm B choose to invest in a corporate bond paying 10% in taxable income or a
municipal bond paying 8% in tax-exempt income?

Without estimating the marginal tax rate, most people answer corporate bonds because they assume that
Firm B had a 0% marginal tax rate in 1989 because the 1987 NOL offset all the 1989 income. Yet the marginal
tax rate was 30.8% and suggests that Firm B should invest in municipal bonds. Municipal bonds generate 8%
after taxes, and corporate bonds generate 6.9% after taxes [10% (1 30.8%)].

Types of Tax Planning

Almost all tax planning, no matter how complex, boils down to three types.

Across character

The most common form of this type of tax planning is converting ordinary income to capital gains when
the capital gains tax rate is lower. Currently, this type is popular with high-income individuals with marginal
ordinary tax rates around 39.6% and marginal long-term capital gains tax rates around 20%. Other examples
include: (1) interest versus operating income to utilize interest deductions; and (2) domestic versus foreign
income to utilize foreign tax credits.

Across entity

The example that hits closest to home is allocating income to a taxable savings account or a tax-deferred
savings account. Should you hold corporate bonds in a typical taxable savings account or in a tax-favored 401(k)
or traditional individual retirement account (IRA)? While the answer also depends on many other nontax
factors, taxpayers generally find holding fully taxable bonds in a 401(k) or IRA, where the interest is not taxed
until you withdraw the money, more beneficial. In a multijurisdictional setting, should a corporation allocate
money to its U.S. parent or foreign subsidiary? Again, the answer depends on many factors, but different global
tax rates across entities within the same multinational corporation can provide many tax-planning opportunities.
Page 7 UVA-C-2185

Across time

Generally, the time value of money suggests that you defer (accelerate) paying taxes (taking deductions).
Changes in tax rates, however, can change that tax-planning scenario. If tax rates go up in the future, taxpayers
may find that it is beneficial to accelerate paying taxes and defer taking deductions.

Why Do Governments Tax?

Governments tax to raise money to pay for public goods and services and change social behavior while
trying to administer a tax system in a cost-effective and equitable manner.

Raise revenue for services

Governments must raise enough revenue to provide goods and services to their citizens. In 2014, federal
taxes comprised 17.5% of the gross domestic product (or $3 trillion).3 If the government does not raise enough
money through taxes, it must borrow money by issuing debt to cover the costs. Borrowing money can be a
short-term fix for a revenue shortfall, but it is not without costs. The government must pay interest to its debt
holders just like any other borrower. The higher the national debt then the larger the percentage of tax revenue
the government must use to cover the interest payments on the debt. In 1940, interest was only $899 million
and 9% of total government outlays. In 1982, interest expense grew to $52 billion but was still 9% of total
government outlays. Interest as a percentage of government outlays peaked at 15% in the 1990s. In the early
2000s, interest dropped back to 9% or below of total government outlays but is projected to return to close to
13% by 2025 as a result of the projected deficits and interest rates (Figures 1 through 4).

Figure 1. Federal outlays: interest (in millions of dollars).

900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
1964

1970

1976

1982

1988

1994

2000

2006

2012
1940
1943
1946
1949
1952
1955
1958
1961

1967

1973

1979

1985

1991

1997

2003

2009

2015
2018e
2021e
2024e

Data source: Federal Reserve Bank of St. Louis FRED Economic Data website, https://fred.stlouisfed.org/series/FYOINT (accessed
Aug. 15, 2016).

3 http://www.taxpolicycenter.org/briefing-book/what-are-sources-revenue-federal-government-0 (accessed Aug. 10, 2016).

Page 8 UVA-C-2185

Figure 2. Federal outlays: net (in millions of dollars).

7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

1985
1940
1943
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982

1988
1991
1994
1997
2000
2003
2006
2009
2012
2015
2018e
2021e
2024e
Data source: Federal Reserve Bank of St. Louis FRED Economic Data website, https://fred.stlouisfed.org/series/FYONET (accessed
Aug. 15, 2016).

Figure 3. Interest as percentage of federal outlays.

0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
1997
1940
1943
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994

2000
2003
2006
2009
2012
2015
2018e
2021e
2024e

Data source: Federal Reserve Bank of St. Louis FRED Economic Data website, https://fred.stlouisfed.org/series/FYOINT;
https://fred.stlouisfed.org/series/FYONET (accessed Aug. 16, 2016).
Page 9 UVA-C-2185

Figure 4. Gross federal debt held by public as percentage of GDP.

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1976
1978
1980
1982
1970
1972
1974

1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016e
2018e
2020e
2022e
2024e
Data source: Federal Reserve Bank of St. Louis FRED Economic Data website, https://fred.stlouisfed.org/series/FYPUGDA188S (accessed Aug.
16. 2016).

Governments can change tax revenues in several ways. They can change the tax rate or the tax base of an
existing group of taxpayers, or they can create a new group of taxpayers. These options vary in their political
attractiveness. Creating a new group of taxpayers is highly visible, depending on the size of the new group and
the amount of the tax (e.g., imposing a new federal excise tax on cellular phone users versus imposing a federal
tax on not-for-profit organizations). Changing a tax rate is also highly visible and can draw very vocal
opposition. For example, various Northern Virginia groups actively campaigned against and succeeded in
stopping a sales tax increase that Governor Warner proposed to combat the budget crisis in 2002. Increases in
tax rates are more opposed by the public than decreases in tax rates, and politicians avoid advertising raising
tax rates while they avidly promote lowering tax rates, especially when nearing an election year. Governments
can also change taxes by altering the tax base. An example of increasing the federal tax base is the reduction of
itemized deductions for high-income individuals. Raising the tax base increases tax revenue but draws less
attention and may be an easier political move than raising tax rates. The Tax Reform Act of 1986 (TRA86)
dramatically changed tax rates and the tax base. For example, TRA86 dropped the highest individual tax rate
on ordinary income from 50% to 28%, but it also eliminated many deductions that increased the tax base.

Change social behavior

Governments pass tax subsidies to encourage behavior that they feel benefits their society and impose
additional taxes to discourage behavior that they feel is detrimental to their society. For example:

Home mortgage interest deductions are meant to encourage home ownership;

Deferral on income earned on investments in IRAs or 401(k)s is meant to encourage savings;
Tax holidays in Ireland are meant to encourage economic development in Ireland by foreign
corporations; and
Cigarette excise taxes are meant to discourage smoking.
Page 10 UVA-C-2185

Unfortunately, actual social behavior may not conform because of the nontax costs associated with the tax-
favored behavior, and the wrong parties may gain unintended benefits.4

Cost effective

Governments want to raise revenue as cheaply as possible, and taxpayers want to pay taxes in a convenient
manner. The biggest complaints about the current U.S. tax system are that the governments administrative
costs and the taxpayers compliance burdens are too high. While many individual taxpayers do not have to file
tax returns because their income is below a certain threshold, the average individual taxpayer spends 27 hours
on tax matters. A typical Fortune 500 company spends approximately $4 million per year on tax matters. The
budget for the Internal Revenue Service (IRS) in 1999 was $7.9 billion, while the requested budget for the IRS
in 2016 increased to $12.9 billion.5 Yet the Government Accounting Office estimates that $406 billion was lost
to intentional and inadvertent noncompliance of individuals and corporations between 2008 and 2010.6

Equitable

Equitable tax systems impose taxes based on the ability to pay. Ability to pay can be measured in two ways:
horizontal equity and vertical equity. Horizontal equity is when two entities with the same ability to pay have
the same tax base. Vertical equity is when two entities with the same ability to pay have the same tax rate. By
taxing those with more ability to pay in an effort to raise revenue for public goods and services, the government
redistributes wealth from the rich to the poor.

Assume two taxpayers earn $100,000, but one is single, and the other is married with a nonworking spouse
and five children. Do these two taxpayers have the same ability to pay taxes? If we only consider salaries, they
have the same ability. If we include family status as a criterion, then the taxpayer with five children has less
ability to pay. Granting personal exemptions for dependents is a way governments, which include family status
in their measure of ability to pay, change a taxpayers tax base to provide more horizontal equity.

Governments could also lower tax rates based on family status to provide more vertical equity. The rate
structure in the United States is an example of vertical equity. As a taxpayers taxable income (ability to pay)
increases, tax rates increase to create vertical equity.

These four components of a tax system (raise revenue, change social behavior, make cost effective, and
make equitable) lead to varying marginal tax rates across character, entity, and time, which provide incentives
for tax planning.

Why Do Governments Allow Tax Planning?

First, the U.S. courts have ruled that taxpayers have the right to arrange their affairs in order to pay as little
tax as possible as permitted by the law.7 The question that arises from the court rulings is what is allowed by
the law. Tax planning allowed by law is called tax avoidance, while tax planning disallowed by law is called tax
evasion, and the line between them differs depending on the interpreter.

4Individuals within the government may also push for tax rules that favor certain constituencies in order to gain their favor.
5Joel Slemrod and Jon Bakija, Taxing Ourselves: A Citizens Guide to the Great Debate over Tax Reform; Internal Revenue Service, Program Summary by
Appropriations Account and Budget Activity, https://www.irs.gov/PUP/newsroom/IRS%20Budget%20in%20Brief%20FY%202016.pdf (accessed
Aug. 5, 2016).
6 http://www.gao.gov/key_issues/tax_gap/issue_summary (accessed Aug. 17, 2016).
7 Commissioner v. Newman, 159 F2d (CA-2, 1947).
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Second, the government is usually an uninvited, silent (no voting rights) party to all contracts, yet it cannot
write and monitor individual contracts with every party and be cost effective. Therefore, the government writes
one contract for all taxpayers (e.g., the Internal Revenue Code), which determines how much and when the
government will take its cut. While the government monitors this one contract, it is impossible to monitor the
parties to the contract in order to prevent all tax planning.

The Dynamic Tax System

When the government takes its cut from a contract, it affects cash flows to the other parties to the contract.
Those cash flows affect the prices that parties are willing to pay to be involved in the contract, and the prices
in turn affect the organizational design of the contract. As taxpayers redesign their organizations to maximize
their after-tax returns, the government rewrites the tax law to stop perceived abuses of the tax system. In its
rewritings, the government benefits from being a party to all contracts because it can make comparisons across
organizations. In response to the governments new law, taxpayers adjust their strategy to incorporate the new
law, which leads the government to write new laws again. The tax system becomes a dynamic process that leads
to its complexity. The number of pages governing U.S. tax law has risen from 400 in 1913 to 74,608 in 2014,
as the government tries to cope with the dynamics of the tax system (Tables 1 and 2).

With a dynamic tax system, businesspersons should consider the reversibility and adaptability of any
strategy. Some contracts contain clauses that void or adjust the contract if changes in the tax law arise that make
the contract suboptimal. If a contract cannot be explicitly reversed with a written clause in the contract, then
the adaptability of the strategy to other alternatives should be assessed.

Table 1. Pages of Federal Tax Law Regulations and Related Materials.

1913 400 1984 26,300
1939 504 2004 60,044
1969 16,500 2014 74,608

Source: Scott A. Hodge, Putting a Face on Americas Tax Returns: A Chart Book, Tax Foundation, October
21, 2013, http://taxfoundation.org/slideshow/putting-face-americas-tax-returns (accessed Aug. 16, 2016).

Table 2. Examinations of 2013 Individual Tax Returns as a Percentage of

Total Returns and a Percent of Returns Examined.
Percent of all Percent
Level of adjusted gross income (AGI) returns examined
All returns 100.00 0.86
Less than or equal to $0 1.83 5.26
$1 under $25,000 39.08 0.93
$25,000 under $50,000 23.32 0.54
$50,000 under $75,000 13.12 0.53
$75,000 under $100,000 8.33 0.52
$100,000 under $200,000 10.70 0.65
$200,000 under $500,000 2.87 1.75
$500,000 under $1,000,000 0.48 3.62
$1,000,000 under $5,000,000 0.24 6.21
$5,000,000 under $10,000,000 0.02 10.53
$10,000,0000 or more 0.01 16.22
Data source: Internal Revenue Service Data Book, 2014, https://www.irs.gov/pub/irs-soi/14databk.pdf (accessed Aug. 16, 2016).
Page 12 UVA-C-2185

Restrictions

The government writes the tax law using both specific and broad statutory and judicial restrictions. Specific
restrictions are usually more detailed and narrow in their scope as they try to eliminate specific tax planning. In
many cases, however, taxpayers can alter their strategies slightly to avoid falling under the specific restriction.
Broad restrictions are vague by design to prevent tax planners from circumventing the law with slight variations,
but they leave the scope of the restrictions open to interpretation. The government and taxpayers often differ
on the interpretation of these restrictions, and the courts must resolve the disagreement. Because the broad
concepts are open to interpretation, the interpretation can change over time.

Example of specific restrictions

Section 1259: The elimination of shorting against the box: As part of the 1997 Tax Act, Congress passed Section
1259, which eliminates a common tax-planning strategy of the wealthy known as shorting-against-the-box. With
a shorting-against-the-box strategy, a taxpayer wants to monetize her appreciated position in the securities of a
company but does not want to pay taxes on the gain. Instead of selling her original shares, she borrows shares
of the same company and sells the borrowed shares (i.e., short sale). She eventually pays tax on the gain in her
original shares when she closes out the short position by repaying the borrowed shares with her original shares.
Through this transaction, she raises the cash that she needs, and she is no longer subject to the risk of changing
stock prices just as if she sold the shares. She also defers the tax on the sale of her original shares. Section 1259
eliminates this strategy by requiring taxpayers to pay tax on an appreciated position if they eliminate their risk.
The narrow scope of the new rule has allowed new variations of the old tax strategy to flourish. Now, taxpayers
only eliminate a portion of the risk and do not fall within Section 1259.

Examples of broad restrictions

Constructive receipt: The constructive-receipt doctrine requires taxpayers to pay taxes on income if they have
access to, but do not actually have receipt of, the income.

Business purpose: The business-purpose doctrine allows the government to recharacterize a transaction if the
only purpose of the transaction is to minimize taxes.8

Substance over form: The substance-over-form doctrine allows the government to look to the economics of a
transaction rather than its legal form to assess its tax consequences.9

Step transaction: The step-transaction doctrine allows the government to collapse multiple transactions that
occur within a short time frame (usually less than a year) into one transaction and assess the tax consequences
on the one collapsed transaction.

Assignment of income: The assignment of income doctrine prevents taxpayers from assigning income to other
parties with lower tax rates (such as a spouse or child) in order to lower the overall tax liability of all the parties.
The taxpayer who earns the income must pay the taxes.10 To assign income to another party, the assigner must
give away his rights to the asset generating the income.11

Tax planning is easier when the contracting parties have a mutual trust and common interest. The IRS
views contracts between related parties as more likely to have these two characteristics. As a result, the IRS may

8 Gregory v. Helvering, 293 US 465 (1935).

9 National Lead Co. v. CIR, 336 F2d 134 (2d Cir. 1964).
10 Lucas v. Earl, 281 US 111 (1930).
11 Helvering v. Horst, 24 AFTR 1058, 40-2 USTC (USSC, 1940).
Page 13 UVA-C-2185

look to apply broad restrictions toward related parties more often, and the Internal Revenue Code has specific
rules to stop tax planning between related parties.

Sources of the U.S. Federal Tax Law

Many sources comprise the U.S. tax laws. The laws passed by Congress make up the Internal Revenue
Code. However, the implementation of the laws passed by Congress may be unclear, so the U.S. Department
of Treasury issues regulations to help taxpayers interpret the law. The IRS rules on specific issues through revenue
rulings and procedures. Even with the regulations, rulings, and procedures ambiguity may exist as to the appropriate
tax treatment, and disagreements may arise between the IRS and the taxpayer. As with many disagreements,
the courts arbitrate. Therefore, judicial decisions provide even more guidance on the interpretation of the tax law.

In the federal court system, there are several outlets for trying a federal tax case. The U.S. District Court
provides the only opportunity for a jury trial. The jury is made up of members of the community just as in any
other jury trial. Also, as in any other district court case, the precedence set by prior decisions in a district should
be investigated before determining where to litigate. Prior decisions within a district weigh more than prior
decisions from another district. If you want a tax expert to decide your case, you would want to try the case in
the U.S. Tax Court. In the U.S. Tax Court, judges hear only tax cases and decide the outcomes. Judges also
decide the outcomes in the U.S Court of Federal Claims, but these judges hear many different types of cases.
The losing party in any court can appeal to the U.S Circuit Court of Appeals, and legal precedence is circuit
specific. Finally, the losing party at the Appeals Court can appeal to the U.S. Supreme Court, but it does not
hear many tax cases.

The size of the deficiency that the IRS claims the taxpayer owes may also play into the venue decision. The
U.S. Tax Court is the only venue where the taxpayer does not have to pay the deficiency before going to court.
In the other venues, the taxpayer must pay the deficiency and sue for a refund. One reason GlaxoSmithKline
may have filed their petition in the U.S. Tax Court in 2004 is because their $5.2 billion deficiency is
approximately 14% of their total assets.

Bottom line: Choosing the right venue to try a case is an important strategic decision in any litigation.

Generally accepted accounting principles (GAAP) versus tax law

Both GAAP and the tax law measure income, but their objectives differ. GAAP tries to prevent the
overstatement of income while the tax law tries to prevent the understatement of income. While GAAP and
the tax law are not completely independent, the different objectives lead to many areas where GAAP and tax
law are not the same. The difference in the two sets of measurement rules gives rise to differences in pretax
income for financial accounting and tax purposes (book-tax income differences). There are two types of book-
tax income differences: permanent and temporary.

Permanent differences: Permanent differences arise from income or expenses that are included in the
calculation of pretax income for either financial accounting or tax purposes but are never included in the other.
One example of a permanent difference is municipal bond interest income. Municipal bond interest income is
included in financial accounting income but is never included in taxable income and leads to a permanent difference
between these two measures of pretax income. While pretax income reported for financial accounting and tax
purposes will reflect permanent differences, the income tax expense reported for financial accounting and tax
purposes will not reflect the permanent income differences. Continuing with our municipal bond example,
pretax income for financial accounting purposes will include interest from the municipal bond, but income tax
expense for financial accounting purposes will not reflect any taxes attributable to the municipal bond interest.
Page 14 UVA-C-2185

As a result, income tax expense reported on the income statement is lower than expected given the level of
pretax income for financial accounting purposes. The rate reconciliation in the income tax footnote of the
financial statements lists the effect of permanent book-tax income differences on income tax expense for
financial accounting purposes. It reconciles the amount of income taxes expected for financial accounting
purposes (pretax income statutory tax rate) to the actual income tax expense on the income statement (pretax
income effective tax rate).

Temporary differences: Temporary differences arise from income or expenses that are included in the
calculation of pretax income for financial accounting and tax purposes, but the timing of the inclusion of the
income or expenses differs for financial accounting and tax purposes. Depreciation is an example of a
temporary difference. Typically, companies use an accelerated depreciation method for tax purposes, but use a
straight-line depreciation method for financial accounting purposes. As a result, depreciation expense will be
higher for tax purposes than financial accounting purposes in the early years of an assets life. In the later years,
depreciation expense associated with the asset will be lower for tax purposes than financial accounting purposes.
But the assets total depreciation expense that is included in pretax income for financial accounting purposes
over time will be the same as the total depreciation expense included in pretax income for tax purposes over
time. During the early (later) years, the tax due to the government will be less (more) than the total tax expense
recorded for financial accounting purposes. For financial accounting purposes, the income statement reports
total tax expense in two parts: current and deferred. Theoretically, current tax expense is the tax due to the
government on the pretax income, and deferred tax expense is the difference between the total tax expense
recorded for financial accounting purposes and current tax expense.

Differences between pretax income for financial accounting and tax purposes can raise concern at the IRS.
Research shows that the IRS is more likely to assess a higher adjustment if the corporation shows a large
difference between pretax income for financial accounting and tax purposes.12

A few final clarifications about terminology:

When a cost incurred by an entity reduces income for financial accounting purposes, people say the
cost is an expense, or it was expensed. When a cost incurred by an entity reduces income for tax
purposes, people often say the cost is a deduction, or it is deductible. Both terms mean a reduction of
pretax income.
Pretax income for tax purposes is usually referred to as taxable income.
Net income is used for financial accounting purposes and is a measure of income after taxes.

Basic Terminology

Income/gain or loss

Income/gain or loss on the exchange of an asset in a taxable transaction is the amount of consideration
received for the asset less the adjusted basis in the asset. The adjusted basis is the original cost of the asset plus
improvements less accumulated depreciation or amortization (for tax purposes).

12 L. Mills, Book Tax Differences and Internal Revenue Service Adjustments, Journal of Accounting Research 32 (2) (1998): 343356.
Page 15 UVA-C-2185

Character of income/gain or loss

The character of income/gain and loss can be ordinary or capital. The character is important because it
determines:
The tax rate at which the income/gain or loss is taxed; and
Whether any limitations on losses apply.

General rule
Ordinary income/loss results from the sale of noncapital assets (e.g., inventory, accounts receivable, trade
or business, real or depreciable assets held for one year).
Capital gain/loss results from the sale of capital assets (e.g., securities, personal use assets, goodwill).
Losses from personal-use property are not deductible (e.g., personal car).

Exception: Section 1231 assets are trade or business, real or depreciable assets held for > one year. To determine the
consequences from the sale of 1231 assets, net the gains and losses from the sale of all 1231 assets, and if the
net result is a:

Net gain: Treat as a long-term capital gain except for any depreciation recapture. Specifically, the portion of the
net gain that is equal to the accumulated depreciation or amortization associated with an asset is taxed
as ordinary income and is referred to as depreciation recapture. Any net gain in excess of the accumulated
depreciation is a long-term capital gain.
Net loss: Treat as an ordinary loss.

Tax Rates

In the spring of 2003, Congress passed the Jobs and Growth Tax Relief and Reconciliation Act of 2003
(JGTRRA). While the JGTRRA affected many items, the changes in tax rates for several types of income
received by individuals attracted the most attention. These rates were in effect until 2013, when they reverted
to the levels in effect prior to enactment of the JGTRRA.

Ordinary income/loss

When ordinary income is greater than ordinary losses, resulting in net ordinary income, the tax rates on the
net amount differ depending on the entity being taxed. The JGTRRA lowered the maximum statutory tax rate
for individual taxpayers from 38.6% to 35%. While individuals and corporations face different tax rate
schedules, the maximum statutory tax rate for individuals and corporations was equivalent (35%) beginning in
2003. In 2013, the maximum individual tax rate increased to 39.6% while the corporate tax rate remained at
35%.

When ordinary income is less than ordinary losses, resulting in net operating losses (NOLs), individuals and
corporations can carry back NOLs to the prior two years to receive a refund of prior taxes paid and carry
forward the remaining NOLs to the next 20 years to reduce taxes on future ordinary income.
Page 16 UVA-C-2185

Capital gain/loss

Capital gains and losses are divided into short term and long term depending on how long a taxpayer holds
the asset (i.e., its holding period). If a taxpayer holds the asset for (>) one year, the capital gain/loss is short
(long) term. A taxpayer must net the long-term capital gains and losses with the short-term capital gains and
losses. (The netting rules for short- and long-term capital gains and losses are somewhat complicated and
beyond the scope of this note.) If a short-term capital gain results from the netting process, both corporations
and individuals are taxed as if the short-term gain is ordinary income. If a long-term capital gain results from
the netting process, only individuals are taxed at a lower tax rate. Corporations do not get a lower tax rate for long-term
capital gains. The JGTRRA lowered the maximum statutory tax rate on long-term capital gains from 20% to 15%
for individuals only. In 2013, the rate returned to 20% for individuals with higher ordinary income tax rates.

If a long-term or short-term capital loss (NCL) results from the netting process, the tax treatment differs
depending on the entity.

Individuals can offset $3,000 of ordinary income with NCLs in the current year and carry forward NCLs
indefinitely. They cannot carry NCLs back to prior years.

Corporations cannot offset any ordinary income with NCLs, but they can carry back NCLs to offset net
capital gains from the prior three years and get a refund of prior taxes paid and carry forward the NCLs for five
years to offset future capital gains.

Dividends

Tax rates on dividends also differ depending on the entity being taxed. Prior to 2003, dividends paid to
individuals were taxed as ordinary income. After the enactment of the JGTRRA, dividends paid to individuals
were taxed as long-term capital gains beginning in 2003.13 In 2013, the tax rate on dividends increased to 20%
because the income was still treated as long-term capital gains. Corporations do not treat dividends as long-term capital
gains.

The tax rate on dividends received by corporations varies with the corporations ownership in the company
paying dividends. The tax rate varies because a corporation receives a deduction for the dividends received
(DRD) that is based on its ownership in the company paying dividends. If a company owns less than 20% of
the dividend-paying company, it receives a deduction equal to 70% of the dividend. For ownership between
20% and less than 80%, the deduction is 80% of the dividend, and for ownership greater than or equal to 80%,
the deduction is 100% of the dividend (Table 3).

13 While 15% is the maximum tax rate for most dividends earned by individuals, not all dividends paid to individuals are eligible for the lower tax rate.
Page 17 UVA-C-2185

Table 3. Federal income tax rates.

2016 Maximum Tax Rate* Individual Corporate
Ordinary Income 39.6% 35%
Short-Term Capital Gain 39.6% 35%
Long-Term Capital Gain 20% 35%
Dividend 20% Varies by percentage of ownership
Percentage of Ownership
< 20 % N/A 10.5% = 35% (1 70%)
20% X < 80% N/A 7% = 35% (1 80%)
80% N/A 0% = 35% (1 100%)
* Income tax rates do not include federal payroll taxes such as Medicare and Social Security.
Source: Created by author.

Three general questions a taxpayer should ask herself when any transaction occurs:

1. Does a taxpayer recognize a gain or loss on the asset given up on the date of the transaction?

In a taxable event: Gain or loss is recognized.

In a tax-deferred event: Gain or loss is not recognized.

This answer determines if a current tax liability or tax benefit exists on the date of the transaction. When a
taxpayer receives cash for an asset, a taxable event usually occurs. When a taxpayer receives stock for an asset,
a tax-deferred event can (but does not always) occur.

2. What is the taxpayers adjusted basis in the asset received?

In a taxable event: The fair market value (FMV) (i.e., price paid for the asset received)

In a tax-deferred event: The adjusted basis of the asset a taxpayer gives up to pay for the asset
received.

This separation makes sense. In a taxable event, a taxpayer recognizes a gain (loss) and pays taxes (receives
a tax benefit) on the asset given up. Because the tax consequences have occurred on the asset given up, the
asset received by a taxpayer takes a basis equal to the price that she pays for it. This basis insures that the gain
or loss that has already been recognized on the asset given up by a taxpayer will not be recognized again. On
the other hand, a taxpayer does not recognize a gain or loss in a tax-deferred event. Therefore, the asset received
by a taxpayer takes on the basis of the asset given up to insure that the gain or loss inherent in the asset given
up will be recognized in the future. The gain or loss on the asset given up will eventually be recognized by a
taxpayer upon a taxable exchange of the asset received (i.e., the gain/loss on the original asset is deferred until
a taxpayer sells the new asset in a taxable event).

This answer is important because it determines the amount of future depreciation or amortization
deductions (if the asset is depreciable), as well as the gain or loss recognized on the future taxable exchange of
the asset.
Page 18 UVA-C-2185

3. When does the holding period of the asset received begin?

In a taxable event: The day after the exchange

In a tax-deferred event: Include the holding period of the asset given up.

This answer determines the character of the gain or loss on a capital asset. The character of a capital asset
determines the tax rate used upon a future taxable exchange of the asset received. If the holding period of an
asset is less than or equal to a year, then a short-term capital gain/loss occurs in a taxable exchange. If the
holding period is greater than a year then a taxable exchange results in a long-term capital gain/loss.

Example

On January 1, 2003, two taxpayers exchange capital assets. Each asset is worth $2,000. Taxpayer 1 bought
her asset on June 30, 2002, for $500, and taxpayer 2 bought his asset on January 1, 2001, for $3,000 (Figure 5).

Figure 5. Example of tax consequences of the exchange of capital assets

FMV = $2000
ADJUSTED BASIS = $3000
HOLDING PERIOD = 2 years
2YEARS

TAXPAYER #1 TAXPAYER #2

FMV = $2000
ADJUSTED BASIS = $500
HOLDING PERIOD = 6
months
Taxpayer #1 Taxpayer #2
Taxable event
Asset given up:
Gain/loss recognized $2000 $500 = $1500 gain $2000 $3000 = $1000 loss
Type of gain/loss Short-term capital gain Long-term capital loss
Asset received:
Adjusted basis $2000 $2000
Holding period begins January 1, 2003 January 1, 2003
Tax deferred event
Asset given up:
Gain/loss recognized $0 $0
Asset received:
Adjusted basis $500 $3000
Holding period begins June 30, 2002 January 1, 2001
Source: Created by author.