TAX PLANNING
TEST BANK, Chapter 12
Multiple Choice
Choose the best answer for each of the following questions:
1. Which of the following is a feature of a properly accomplished tax planning?
a. It allows the tax professional to exercise a higher degree of creativity.
b. It forces the client to identify financial goals and general means by which to achieve them.
c. It offers a legal way to avoid taxes.
d. All of the above.
Answer: d
Rationale:
Properly accomplished tax planning involves various aspects, including leveraging creativity
to find innovative solutions, helping clients identify financial goals and strategies, and
utilizing legal methods to minimize tax liabilities. Therefore, all the options provided exercising creativity, assisting clients in goal identification, and offering legal tax-saving
strategies - are features of effective tax planning.
2. Which of the following tax law rules create incentives for tax planning?
a. The Federal income tax itself is deductible in determining taxable income.
b. Reducing the amount of income taxes that are paid decreases a taxpayer’s allowable
deductions.
c. The Federal income tax itself is not allowed as a deduction in determining taxable income.
d. None of the above.
Answer: c
Rationale:
Tax law rules that disallow the deduction of the Federal income tax itself in determining
taxable income create an incentive for tax planning. This is because taxpayers cannot reduce
their taxable income by deducting the Federal income tax paid, encouraging them to explore
other legal avenues for reducing their tax liabilities.
3. Where ATC = after-tax cost, BTC = before-tax cost, and MTR = marginal tax rate, the
after-tax cost of tax planning can be expressed as:
a. ATC = BTC × (1-MTR).
b. a factor of the time value of money.
c. MTR × taxable income =ATC.
d. ATC = BTC ÷ (1-MTR).
Answer: a
Rationale:
The after-tax cost (ATC) of tax planning is the before-tax cost (BTC) reduced by the tax
savings achieved, which is calculated as BTC multiplied by (1 - MTR), where MTR is the
marginal tax rate. This formula accounts for the tax savings obtained through effective tax
planning.
4. Which of the following is the basic formula for computing a taxpayer’s tax liability?
a. Tax Liability = Tax Base ÷ Tax Rate
b. Tax Liability = Tax Base × (1 – Tax Rate)
c. Tax Liability = Tax Base × Tax Rate
d. None of the above.
Answer: c
Rationale:
The basic formula for computing a taxpayer’s tax liability is Tax Liability = Tax Base × Tax
Rate. This formula calculates the tax liability by multiplying the taxable base (such as income
or sales) by the applicable tax rate.
5. Which of the following is true about the Tax Reform Act of 1986?
a. It lowered the top individual income tax rate from 50 percent to 28 percent.
b. It decreased the capital gains rate.
c. It lowered the bottom individual income tax rate from 15 percent to 11 percent.
d. All of the above.
Answer: a
Rationale:
The Tax Reform Act of 1986 indeed lowered the top individual income tax rate from 50
percent to 28 percent, making option a the correct choice. The Act also made significant
changes to the tax code, simplifying the tax system and closing various loopholes.
6. Which of the following is the most common tax that is found in contemporary
industrialized societies?
a. A tax on consumption.
b. A proportional tax.
c. A tax on income.
d. A property tax.
Answer: c
Rationale:
A tax on income is the most common type of tax found in contemporary industrialized
societies. It is levied on individuals and businesses based on their income, wages, profits, or
other sources of earnings.
7. A proportional tax rate system represents:
a. an increasing tax rate structure.
b. a flat tax rate structure.
c. the U.S. federal income tax system.
d. none of the above.
Answer: b
Rationale:
A proportional tax rate system, also known as a flat tax rate structure, applies the same tax
rate to all taxpayers regardless of their income level. Therefore, option b accurately describes
a proportional tax rate system.
8. Under a regressive tax rate system, the applicable tax rate:
a. increases as the tax base grows larger.
b. remains unchanged irrespective of the level of tax base.
c. best reflects the capacity of the taxpayer to pay.
d. decreases as the tax base grows larger.
Answer: d
Rationale:
In a regressive tax rate system, the applicable tax rate decreases as the tax base grows larger.
This means that individuals with lower incomes pay a higher proportion of their income in
taxes compared to those with higher incomes.
9. Under a progressive tax rate system, the applicable tax rate:
a. is applied against the taxpayer’s net holdings of tangible assets.
b. decreases as the tax base grows larger.
c. increases as the tax base grows larger.
d. is independent of the tax base.
Answer: c
Rationale:
In a progressive tax rate system, the applicable tax rate increases as the tax base grows larger.
This means that individuals with higher incomes are subject to higher tax rates, reflecting a
principle of taxation where those with greater financial ability contribute a larger share of
their income in taxes.
10. Which of the following tax rate systems is applicable to the U.S. individual income tax?
a. Proportional tax rate system.
b. Regressive tax rate system.
c. Progressive tax rate system.
d. None of the above.
Answer: c
Rationale:
The U.S. individual income tax operates under a progressive tax rate system, where tax rates
increase as taxable income rises. This system is designed to impose a greater tax burden on
individuals with higher incomes, reflecting principles of fairness and ability to pay.
11. Most sales and property taxes in the U.S. employ a:
a. proportional rate structure.
b. regressive rate structure.
c. progressive rate structure.
d. consumption rate structure.
Answer: a
Rationale:
Most sales and property taxes in the U.S. employ a proportional rate structure, where the tax
rate remains constant regardless of the taxpayer's income or wealth. This means that all
taxpayers, regardless of their financial situation, pay the same rate of tax on their sales or
property transactions.
12. The tax rate that is applied on the next dollar of taxable income is referred to as the:
a. marginal tax rate.
b. effective tax rate.
c. before-tax cost.
d. None of the above.
Answer: a
Rationale:
The tax rate that is applied on the next dollar of taxable income is known as the marginal tax
rate. It represents the rate at which additional income is taxed and is a crucial factor in tax
planning decisions, as it determines the cost or benefit of earning extra income.
13. The tax rate which is computed by simply dividing the total tax liability by the
corresponding tax base is known as the:
a. capital gains tax rate.
b. average tax rate.
c. effective tax rate.
d. marginal tax rate.
Answer: b
Rationale:
The tax rate computed by dividing the total tax liability by the corresponding tax base is
known as the average tax rate. It provides an overall measure of the taxpayer's tax burden
relative to their taxable income and is useful for assessing the overall impact of taxes on
financial decisions.
14. Tax planning:
a. is a completely legal means for saving taxes.
b. has as its goal tax evasion.
c. endeavors to understate the taxpayer’s real wealth.
d. is all of the above.
Answer: a
Rationale:
Tax planning involves using legal strategies and provisions within the tax code to minimize a
taxpayer's tax liability. It is a legitimate and ethical practice aimed at optimizing a taxpayer's
financial situation within the boundaries of the law. Options b and c describe illegal or
unethical activities (tax evasion and understating wealth), which are not part of legitimate tax
planning practices.
15. Taxpayers often can legally reduce their exposure to taxation by:
a. avoiding the accumulation of gross income that must be recognized.
b. deducting federal taxes.
c. not appearing before tax officials.
d. postponing deductions.
Answer: a
Rationale:
Taxpayers can legally reduce their exposure to taxation by utilizing various tax planning
strategies, such as deferring income recognition, maximizing deductions, and taking
advantage of tax credits and incentives. Option a specifically highlights the strategy of
avoiding the accumulation of gross income that must be recognized, which can help
taxpayers minimize their taxable income and overall tax liability.
16. Jane owns land adjacent to her home that appreciated in value by $5,000 this year. She
acquired the land five years ago for $25,000. Based on these facts alone, the amount that
would be included in her taxable income for the current year is:
a. $30,000
b. $25,000
c. $5,000
d. $0
Answer: d
Rationale:
Under U.S. tax law, unrealized gains on assets such as appreciated land are not included in
taxable income until the asset is sold or otherwise disposed of. Since Jane has not sold the
land and is simply experiencing an increase in its value, there is no taxable income to report
for the current year.
17. David Jacob, a salaried person, incurred a loss of $4,000 from passive activities. This loss
can be applied as a deduction to offset taxable income from:
a. his salary.
b. his long-term capital gains for the year.
c. passive activities.
d. any source.
Answer: c
Rationale:
Losses from passive activities can generally be used to offset income from other passive
activities. Therefore, David's $4,000 loss from passive activities can be applied as a deduction
to offset income from other passive activities, but not to offset his salary or long-term capital
gains.
18. Choosing tax-free fringe benefits instead of an equivalent hike in salary is an example of
tax planning by:
a. accelerating income recognition.
b. changing the timing of recognition of taxable income.
c. avoiding income recognition.
d. All of the above.
Answer: c
Rationale:
Choosing tax-free fringe benefits instead of salary is an example of tax planning by avoiding
income recognition. By opting for non-taxable benefits, the taxpayer reduces their taxable
income, thereby lowering their overall tax liability.
19. Allowing an investment to increase in value without selling it is an example of tax
planning by:
a. changing the timing of recognition of taxable income.
b. changing the character of income.
c. spreading income among related parties.
d. Only (a) and (b).
Answer: a
Rationale:
Allowing an investment to increase in value without selling it is an example of tax planning
by changing the timing of recognition of taxable income. The gain on the investment is not
realized until the asset is sold, delaying the recognition of taxable income.
20. Investing in non-dividend paying stock that is expected to appreciate yearly by 5 percent
instead of investing in 5 percent corporate bonds is an example of tax planning by:
a. spreading income through portfolio diversification.
b. avoiding income recognition.
c. changing the timing of recognition of taxable income.
d. changing the character of income.
Answer: d
Rationale:
Investing in non-dividend paying stock that appreciates in value instead of investing in
corporate bonds with fixed interest payments represents a change in the character of income.
While both investments generate income, the nature of the income differs - capital
appreciation versus interest income. This strategic choice reflects a form of tax planning
aimed at optimizing the tax consequences of investment decisions.
21. What is the age at which children who are not full-time students are no longer subject to
the “kiddie” tax?
a. 24
b. 18
c. 19
d. none of the above.
Answer: c
Rationale:
Children who are not full-time students are no longer subject to the "kiddie" tax once they
reach the age of 19. This provision applies to children who have unearned income above a
certain threshold and are subject to tax at their parents' marginal tax rate until they reach the
age of 19 (or 24 if they are full-time students).
22. For 2010, the amount of exemption that a child can enjoy on any interest, dividends or
capital gains income is limited to:
a. $950.
b. $1900.
c. $10,000.
d. There is no exemption for this type of income.
Answer: a
Rationale:
For the tax year 2010, the amount of exemption that a child can enjoy on any interest,
dividends, or capital gains income is limited to $950. This exemption allows certain unearned
income of children to be taxed at their own lower tax rates or potentially tax-free, up to the
specified exemption amount.
23. Which of the following are the two pervasive judicial doctrines that often limit the
taxpayer’s ability to employ effective planning techniques?
a. the progressive tax rate requirement and marginal rates.
b. business purpose and substance over form.
c. business purpose and changing tax jurisdiction.
d. All of the above are judicial doctrines that limit effective tax planning.
Answer: b
Rationale:
The two pervasive judicial doctrines that often limit the taxpayer’s ability to employ effective
planning techniques are business purpose and substance over form. These doctrines require
that transactions have a legitimate business purpose and that their substance aligns with their
form for tax purposes. Transactions lacking in business purpose or characterized by a
discrepancy between form and substance may be disregarded or recharacterized by tax
authorities, limiting the effectiveness of tax planning strategies.
True or False
Indicate which of the following statements are true or false by circling the correct answer.
1. Taxpayers are rewarded more for finding ways to save taxes than for earning an equal
amount in the marketplace.
Answer: True
Rationale:
Taxpayers are often incentivized to find ways to save taxes because tax savings directly
increase their after-tax income without requiring additional effort or resources. In contrast,
earning an equal amount in the marketplace typically involves more effort, time, and risk.
Moreover, tax savings can be achieved through various legitimate strategies such as
deductions, credits, and tax-deferred investments, providing taxpayers with opportunities to
optimize their financial situation within the confines of the tax law.
2. Under a proportional tax rate system, the tax rate is constant.
Answer: True
Rationale:
In a proportional tax rate system, also known as a flat tax rate structure, the tax rate remains
constant regardless of the taxpayer's income level. This means that all taxpayers, regardless
of their income or wealth, are subject to the same tax rate on their taxable income. Therefore,
it is true that under a proportional tax rate system, the tax rate does not vary based on the
taxpayer's income, remaining constant throughout different income levels.
3. Any business-related expenses that are incurred in connection with the determination of a
tax are not deductible.
Answer: False
Rationale:
Any business-related expenses that are incurred in connection with the determination of a tax
are deductible.
4. With respect to tax planning activities, the decision maker must compare the after-tax
benefits with the pre-tax costs.
Answer: False
Rationale:
One must compare the pre-tax benefits with the after-tax costs.
5. The effective tax rate can be found by dividing the total tax liability by the economic
income.
Answer: True
Rationale:
The effective tax rate is a measure of the average rate at which a taxpayer's income is taxed.
It is calculated by dividing the total tax liability by the economic income, which represents
the taxpayer's total income before any deductions or exemptions. This calculation provides a
comprehensive understanding of the taxpayer's overall tax burden relative to their income,
taking into account various factors such as deductions, credits, and tax brackets. Therefore, it
is true that the effective tax rate can be determined by dividing the total tax liability by the
economic income.
6. Tax planning analyses should be based on the average tax rates that the individual will pay
or save by adopting a particular course of action.
Answer: False
Rationale:
All tax planning analyses should be based on the marginal tax rates that the individual will
pay or save by adopting a particular course of action.
7. Spreading income among related taxpayers is one of the goals of tax planning behavior.
Answer: True
Rationale:
Spreading income among related taxpayers, such as family members or closely held
businesses, is indeed a common goal of tax planning behavior. By distributing income to
individuals or entities with lower tax rates or utilizing tax-efficient structures, taxpayers can
potentially reduce their overall tax liability. This strategy allows for the optimization of tax
outcomes within the bounds of the law, making it a key objective in effective tax planning.
8. When tax rates are constant, delaying income recognition or accelerating deductions can be
beneficial.
Answer: True
Rationale:
When tax rates are constant, delaying the recognition of income or accelerating deductions
can indeed be beneficial for taxpayers. By postponing the receipt of income or advancing
deductible expenses into the current tax year, taxpayers can potentially reduce their taxable
income and overall tax liability. This strategy takes advantage of the time value of money and
the ability to shift income and deductions between tax years to optimize tax outcomes.
Therefore, it is true that under constant tax rates, delaying income recognition or accelerating
deductions can be advantageous tax planning strategies.
9. Taxpayers can use the step-transaction doctrine to obtain various tax advantages.
Answer: False
Rationale:
Taxpayers are restricted to the actual legal form of the transactions in which they engage, but
the IRS has the option of employing the step-transaction doctrine to reduce tax benefits.
10. The first requirement for effective tax planning is awareness on the part of decisionmakers.
Answer: True
Rationale:
Awareness among decision-makers is indeed crucial for effective tax planning. Decisionmakers need to be aware of relevant tax laws, regulations, incentives, and potential tax-saving
strategies to make informed decisions that optimize their tax outcomes. Without awareness of
the tax implications of various financial decisions, taxpayers may miss opportunities to
minimize their tax liabilities or inadvertently expose themselves to unnecessary tax burdens.
Therefore, awareness serves as the foundational step in the tax planning process.
11. The judicial doctrine ‘business purpose’ can decrease the taxpayer’s ability to employ
effective planning techniques.
Answer: True
Rationale:
The judicial doctrine of 'business purpose' indeed plays a significant role in limiting the
taxpayer's ability to employ effective planning techniques. This doctrine requires that
transactions have a legitimate business purpose beyond solely obtaining tax benefits.
Transactions lacking a bona fide business purpose may be disregarded or challenged by tax
authorities, thereby decreasing the effectiveness of certain tax planning strategies. By
emphasizing the importance of genuine business motives, this doctrine aims to prevent abuse
of tax laws and ensure that transactions reflect economic substance rather than mere tax
avoidance.
12. Whenever a series of transactions results in significant tax savings, the IRS may attempt
to apply the concept of substance over form by ‘telescoping’ or ‘collapsing’ several
transactions into one.
Answer: True
Rationale:
When a series of transactions results in substantial tax savings, the IRS may indeed seek to
apply the concept of substance over form. This principle allows tax authorities to look
beyond the legal form of transactions and examine their economic substance to determine
their true tax consequences. If the IRS determines that a series of transactions lacks genuine
economic substance and serves primarily to obtain tax benefits, it may 'telescope' or 'collapse'
these transactions into one, treating them as a single transaction for tax purposes. By doing
so, the IRS aims to prevent taxpayers from exploiting technicalities in the tax code to achieve
unintended tax advantages, ensuring that tax liabilities accurately reflect the economic
realities of transactions. Therefore, it is true that the IRS may employ the concept of
substance over form when significant tax savings are involved.
13. With regard to employers, generally, salary payments to employees are deductible but
fringe benefit payments are not.
Answer: False
Rationale:
Generally, both salary payments to employees and fringe benefits payments for employees
are deductible by employers.
14. The ‘Kiddie tax’ was created to prevent parents from sheltering income by putting
accounts in the names of their lower-taxed children.
Answer: True
Rationale:
The 'Kiddie tax' provisions were indeed established to prevent parents from sheltering income
by transferring assets or income-generating accounts to their children who are subject to
lower tax rates. Under the 'Kiddie tax' rules, certain unearned income of children, typically
under a certain age threshold, is taxed at the parents' marginal tax rate rather than the child's
rate, effectively eliminating the tax advantage of shifting income to children. This measure
aims to prevent tax avoidance strategies involving the exploitation of lower tax rates
applicable to children, ensuring that income is taxed at the appropriate rates based on the
economic realities of ownership and control. Therefore, it is true that the 'Kiddie tax' was
created to deter parents from sheltering income through their children.
15. Investment expenses can offset ordinary income.
Answer: False
Rationale:
Investment expenses generally can only be used to offset investment or “portfolio” income.
16. The progressive nature of the tax system tends to increase the advantage of income
splitting.
Answer: True
Rationale:
The progressive nature of the tax system, where tax rates increase as income levels rise,
indeed enhances the advantage of income splitting. Income splitting involves distributing
income among family members or entities in a manner that minimizes the overall tax liability
by taking advantage of lower tax brackets or thresholds. In a progressive tax system, higherincome earners are subject to higher tax rates, creating opportunities for tax savings through
income splitting strategies. By allocating income to individuals in lower tax brackets,
taxpayers can potentially reduce their overall tax burden by shifting income to those who are
taxed at lower rates. Therefore, the progressive nature of the tax system amplifies the benefits
of income splitting, making it a valuable tax planning strategy for optimizing tax outcomes.
17. Taxpayers can always minimize their tax liability simply by moving income and assets
out of one jurisdiction to another.
Answer: False
Rationale:
Although some jurisdictions offer tax benefits to attract businesses to their jurisdiction, these
governments often put in place tax changes to prevent “leakage” of tax revenues through such
cross-border transactions.
Short Answer
1. Tax planning has been said to offer an opportunity for the most psychologically and
financially rewarding work in tax practice. What is it about tax planning that would lead one
to his conclusion?
Answer: For most practitioners, tax planning represents the “glamour” end of the practice
because properly accomplished tax planning (1) forces the client to identify broad financial
goals and general means by which to accomplish them, thereby engaging the practitioner in
more activities than otherwise might be the case; (2) allows the tax professional to show a
higher degree of creativity than in any other part of the practice; and, (3) provides the
practitioner the greatest degree of control over the prescribed transactions and their tax
consequences, especially in open-fact situations.
2. What is a statutory tax trap? Give an example.
Answer: Statutory tax traps are rules designed by Congress to prevent certain techniques of
tax avoidance. For example, Section 482 of the Internal Revenue Code gives the IRS the
power to reallocate both income and deductions among related companies to reflect “true
taxable income.” Under that section, the IRS may make an allocation of income from one
foreign subsidiary to another foreign subsidiary of a U.S. multinational corporation to reflect
the market value of services provided by one subsidiary to the other. The IRS will make this
allocation if the subsidiary providing the services does not charge market value for those
services.
3. Robinson is subject to a 40 percent overall marginal tax rate. Is he better off if he receives
a tax-free fringe benefit of $4,000 than receiving an equivalent raise in his salary? Why or
why not?
Answer: Robinson would be better off if he receives tax-free fringe benefit of $4,000 instead
of an equivalent raise in his salary.
Essay Questions
1. Identify the five goals of tax planning behavior and give an example of each.
Answer: The five main goals of tax planning are:`
• Avoiding recognition of taxable income, such as choosing to receive a tax-free fringe
benefit rather than an increase in a taxable salary.
• Changing the timing of recognition of income, gains, deduction, losses, and credits. For
example, a cash method taxpayer can postpone recognition of income by waiting to bill
clients until next year.
• Changing tax jurisdictions. A multistate company could relocate its warehouse and
distribution center to a jurisdiction with a lower corporate income tax rate.
• Changing the character of income. A taxpayer can invest in a non-dividend paying stock
which will generate capital gains upon sale instead of a corporate bond, where the interest is
taxed currently as ordinary income.
• Spreading income among related taxpayers. Taxpayers can use appropriate trusts to shift
pre-tax income to their aging parents who are in a lower tax bracket.
2. A corporate taxpayer, who is subject to a marginal state and Federal tax rate of 30 percent,
is considering two mutually exclusive alternatives. Alternative A is to hire a public
accounting firm at a cost of $5,000 to undertake research on a tax avoidance plan. If the plan
is successful, it will save the corporation $4,900 in Federal income taxes. The probability of
success for the plan is 75 percent. Alternative B is to hire a marketing firm at a cost of $4,500
to develop a new marketing strategy. If it is successful, the new marketing strategy would
generate new revenues of $5,500. The probability of such success is 80 percent.
Which alternative should the corporation choose?
Answer:
Even though Alternative B offers a higher pretax payoff, a lower before-tax cost, and a higher
probability of success, Alternative A should be accepted.
3. a) David formed a new corporation by investing $200,000 cash. Following the advice of
his tax consultant, David designated $120,000 to be used for the purchase of corporate stock
and $80,000 as a loan to the corporation. What tax advantage does this arrangement have
over structuring the entire investment as a purchase of stock? Explain.
b) Lydia has $30,000 to invest and is considering a corporate bond that pays 7 percent annual
interest or a non-dividend paying stock that is expected to appreciate by 7 percent each year.
Given that both investments are of similar risk, and the long-term capital gains tax rate is
lower than the ordinary income tax rate, which option should Lydia choose? Why?
c) Johnson is the sole shareholder of a management-consulting corporation. In addition, he
has invested in passive rental activities that generate $20,000 per year in passive losses.
According to the Code, such losses from passive activities cannot be applied as deductions to
offset other types of taxable income. Advise Johnson as to how he can salvage the $20,000
deduction.
Answer: a) David formed a new corporation by investing $200,000 cash. Following the
advice of his tax consultant, David designated $120,000 to be used for the purchase of
corporate stock and $80,000 as a loan to the corporation. In this way, if David wants to
receive large amounts of cash back from the corporation in the future, the entity simply will
repay part or all of the loan principal to him, tax free, rather than making a large (taxable and
non-deductible) dividend payment. David also can direct the corporation to pay interest on
the loan; such payments are deductible by the corporation. Of course, both interest and
dividends are taxable to David when he receives them.
b) Lydia has $30,000 to invest and is considering a corporate bond that pays 7 percent annual
interest or a non-dividend paying stock that is expected to appreciate by 7 percent each year.
Interest on corporate bonds is taxed as ordinary income at ordinary tax rates which are higher
than the long-term capital gains tax rate. If risk is similar for both investments, it is better to
choose the investment that results in less tax liability. Capital gains on investments in nondividend paying stock are taxed only when the stock is sold, whereas interest on investment
in corporate bonds is taxed on yearly basis. In the given case, Lydia should choose to invest
in non-dividend paying stock that appreciates by 7 percent each year as it would result in
lower tax liability.
c) Johnson is the sole shareholder of a management-consulting corporation. In addition, he
has invested in passive rental activities that generate $20,000 per year in passive losses.
According to the Code, such losses from passive activities cannot be applied as deductions to
offset other types of taxable income. Accordingly, Johnson cannot reduce current taxable
income by the $20,000 passive loss from his rental activities. However, as the dominant
shareholder of his corporation, Johnson may be in a position to salvage the $20,000
deduction. If he reduces his salary from the corporation by $20,000 and takes instead from
the corporation a $20,000 properly structured lease payment for the use of property that he
owns which the corporation uses for business purposes (such as office equipment or
automobiles), he may be able to create $20,000 in passive income from rental activities,
against which the passive loss can be offset.
Test Bank for Federal Tax Research
Roby B. Sawyers, Steven Gill, Debra Sanders, William A. Raabe, Gerald E. Whittenburg
9781111221645, 9781337282987, 9781285439396
