Tax Planning to Limit Tax Liability

How to Limit Tax Liability

Tax Planning

After Tax cost = Before Tax cost x (1-marginal tax rate)

Example:  Company A has a tax rate of 40% and is considering 2 options.

Option 1: hire worker for $2,000 to set up tax avoidance plan which would save the company $1,600 in income taxes. 80% success rate.

Option 2: Hire worker for $1,800. Work would generate $2,000. 85% success rate.


 Option 1Option 2
Before Tax Cost2,0001,800
Tax Reduction (40%)(800)(720)
After Tax Cost1,2001,080
Potential Pretax Payoff$1,6002,000
Success Probability80%85%
Expected Pretax Payoff12801700
Tax on expected payoff (40%)(0)(680)
Excess of expected – Cost80(60)

Choice 1 would be the better option

Tax Planning


Tax Rate Terminology


Tax liability = Tax Base X Rate


Tax Base

How to Limit Tax Liability


Tax Rates

–          Proportional Tax Rate- everyone pays the same rate

–          Progressive: As tax base increases rates go up

–          Regressive: As tax rates decreases as tax base goes up

–          Average Tax Rate:

  • Example: earns 50,000. Taxable income is $41,000
  • 15% times 10,000 = 1,500
  • 30% times 10,000 = $3,000
  • 40% x 21,000 = $8,400
  • Tax liability is $12,900
  • 12.900/ 41,000 = 31.5 % average tax rate
    • Nominal Average Tax Rate
    • Effective would be 12,900 / 50,000


Tax Planning in Perspective


Fundamentals of Tax Planning

Tax Awareness


Goals of Tax Planning Behavior

–          Avoid income and obtain credits and deductions

–          Postponing income recognition

–          Changing into better tax jurisdictions

–          Control income classification

–          Spreading income to other related taxpayers


Avoiding Income Recognitions

–          Loans are not income

–          Instead of selling a product it can be used

Postponing Income Recognition

–          Delay sale of property

–          Depreciation methods

Changing Tax Jurisdictions

–          Moving to better jurisdictions

–          Filing in better jurisdictions

Controlling Classification of Income

–          Salary or dividend?

–          Ordinary income, investment income, passive income

Spreading Income

–          Gifting money


Departing from Fundamentals

–          Inconsistencies in the Statute

–          Inconsistencies between Taxpayers

–          Inconsistencies between Years


Avoiding Tax Traps

Judicial Tax Traps

The goal if tax planning is to limit tax liability for oneself or your client if you are a tax preparer. There are several methods of doing so. These notes are a quick, but  unofficial reference.


How to Limit Tax Liability

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