Nobody looks forward to tax planning, but it’s something that everyone, at some point, must do.
However, instead of looking at tax planning as a burden, look at taxes as part of the cost of a transaction. The focus, therefore, should not necessarily be on the minimization of taxes but on the maximization of the net present value of after-tax cash flows, says John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, managing director of Cendrowski Selecky PC.
“As an example, if a transaction can be structured multiple ways, the alternative that produces the least amount of taxes may not be the most advantageous with respect to after-tax cash flow,” says Alfonsi. “You should be willing to incur a greater amount of taxes if it will ultimately result in greater after-tax cash flow.”
Smart Business spoke with Alfonsi about tax planning, how to perform it properly and what challenges come along with it.
Are there certain tax planning strategies that always apply?
Nothing fits every scenario. There are certain general tax planning strategies, such as deferring the recognition of income and accelerating deductions, but even these have exceptions. When you know, or are fairly certain, that tax rates will increase, the opposite may be more advantageous accelerating income and deferring transactions.
For example, absent any legislation passing in the next six months, the top marginal income tax rate on ordinary income for individuals is increasing from 35 percent in 2010 to 39.6 percent in 2011. Similarly, the maximum capital gains rate is increasing from 15 percent in 2010 to 20 percent in 2011. Accordingly, taxpayers may want to consider taking advantage of the lower rates in 2010.
What should be considered when it comes to tax planning?
Timing of the transaction is critical to the analysis. Accelerating a deduction from 2011 to 2010 may make sense, given the rate differential, if you would otherwise have incurred that expense in early 2011. The time value of the money used for that expense needs to be considered; it may not make sense on a present value basis to accelerate that deduction if you would have otherwise incurred it in late 2011.
Stated alternatively, the lost time value of the money used to fund the expense may more than offset the incremental tax savings realized with respect to the rate differential. Each transaction and alternative needs to be analyzed, again, with a goal of maximizing the client’s present value of after-tax cash flow.
How does the alternative minimum tax (AMT) affect tax planning for individuals?
The AMT is essentially a flat rate tax based on a separately computed tax base. It does not allow certain deductions such as state taxes, miscellaneous itemized deductions and personal exemptions. In addition, there are items, referred to as preference items, that are added to regular taxable income for purposes of the AMT. Tax planning should consider whether the client is, or will be, subject to the AMT.
Despite the regular tax rate differential for 2010 and 2011, if a taxpayer will be subject to the AMT for both years (essentially no change in tax rates), there may be no benefit in accelerating the recognition of income; accelerating the income may decrease the present value of the after-tax cash flow. Care also needs to be taken with respect to deductions, as shifting deductions between tax years may cause the taxpayer to be subject to the AMT, thereby negating any anticipated tax savings.
What challenges can the IRS make with respect to tax planning strategies?
There are few ways the IRS can challenge the tax consequences of a transaction. With respect to the deferral of income, there is the concept of ‘constructive receipt,’ which means that the income was available to the taxpayer earlier than when it was actually received. The income would be taxable, therefore, when made available to the taxpayer, or constructively received, rather than when actually received.
The IRS may also challenge a result based on the business purpose doctrine. The business purpose doctrine provides that a transaction should not be respected unless it was intended to achieve a genuine business purpose, not just the avoidance of tax.
The substance over form doctrine means that the IRS can look through the legal formalities to determine the economic substance, if any, of a transaction. If the substance differs from the form, the transaction will be recast to reflect its economic realities. Finally, there is the step transaction doctrine, which allows the IRS to collapse a series of interdependent transactions into a single transaction to determine the entire tax consequences of the arrangement.
Does tax planning only apply to federal taxes?
Absolutely not. Tax advisers need to consider the impact, if any, of state taxes in the planning process. Many times, there are opportunities to shift the recognition of income from a higher tax rate jurisdiction to a lower tax rate jurisdiction. Other times, maybe because of the availability of federal tax attributes such as net operating losses, the state tax exposure is greater than the federal tax exposure.
Again, taxes are a transaction cost that requires the tax adviser to identify and quantify all such costs federal and state income taxes, property taxes, capital stock taxes, franchise taxes, etc.