Question 1

Which of the following is an example of the conversion strategy?

Accepted Answer

A high tax rate taxpayer investing in tax exempt municipal bonds is an example of a conversion strategy because it involves converting taxable income into tax-exempt income, thus reducing the taxpayer's overall tax liability.

Question 2

Which of the following is an example of the income shifting strategy?

Accepted Answer

The answer of Which of the following is an example...

Question 3

Assume that Keisha's marginal tax rate is 40% and her tax rate on dividends is 15%. If a city of Atlanta bond pays 7.65% interest, what dividend yield would a dividend-paying stock (with no growth potential) have to offer for Keisha to be indifferent between the two investments from a cash-flow perspective?

Accepted Answer

To find the dividend yield required for Keisha to be indifferent between the two investments, we need to set up the after-tax cash flows for each investment and solve for the unknown dividend yield.

For the bond, the after-tax cash flow would be:

$765 (annual interest) x (1 - 0.4) = $459

For the dividend-paying stock, the after-tax cash flow would be:

Dividend yield x (1 - 0.15) = Dividend yield x 0.85

Set up an equation with the two after-tax cash flows equal to each other:

$459 = Dividend yield x 0.85

Divide both sides by 0.85:

Dividend yield = $459 / 0.85 = 540

So, the required dividend yield is 9%. Therefore, the best choice is (D).

Question 4

Assume that Juanita is indifferent between investing in a corporate bond that pays 10.2% interest and a stock with no growth potential that pays a 6% dividend yield. Assume that the tax rate on dividends is 15%. What is Juanita's marginal tax rate?

Accepted Answer

The answer of Assume that Juanita is indifferent between investing...

Question 5

Assume that Lucas' marginal tax rate is 30% and his tax rate on dividends is 15%. If a dividend-paying stock (with no growth potential) pays an 8% dividend yield, whatinterest rate would a municipal bond have to offer for Lucas to be indifferent between the two investments from a cash-flow perspective?

Accepted Answer

Lucas' after-tax return on the dividend-paying stock is calculated as follows:

After-tax return = Dividend yield x (1 - tax rate on dividends) 
= 8% x (1 - 0.15) 
= 6.8%

Therefore, from a cash-flow perspective, Lucas would be indifferent between the stock and a municipal bond if the bond offered a yield of 6.8%. Therefore, the answer is B.

Question 6

Assume that Marsha is indifferent between investing in a city of Destin bond that pays6% interest and a corporate bond that pays 8% interest. What is Marsha's marginal tax rate?

Accepted Answer

The answer of Assume that Marsha is indifferent between investing...

Question 7

Assume that Larry's marginal tax rate is 25%. If corporate bonds pay 10% interest, what interest rate would a municipal bond have to offer for Larry to be indifferent between the two bonds?

Accepted Answer

Since Larry's marginal tax rate is 25%, he would pay 25% of his interest income in taxes if he invested in corporate bonds. Therefore, the after-tax return on corporate bonds would be 7.5% (10% - 25% of 10%). For Larry to be indifferent between the two bonds, the municipal bond would need to offer an after-tax return of 7.5%. Since municipal bond interest is typically tax-free at the federal level, the pre-tax yield on the municipal bond would also be 7.5%. Therefore, the interest rate on the municipal bond would need to be 7.5%.

Question 8

Investing in municipal bonds to avoid paying tax on interest earned and to earn a higher after-tax yield is an example of:

Accepted Answer

Investing in municipal bonds to avoid paying tax on interest earned and to earn a higher after-tax yield is an example of conversion, as it involves converting taxable income into tax-exempt income, thereby reducing tax liability.

Question 9

Assume that John's marginal tax rate is 40%. If a city of Austin bond pays 6% interest, what interest rate would a corporate bond have to offer for John to be indifferent between the two bonds?

Accepted Answer

To be indifferent, the after-tax yield of the corporate bond should equal the tax-free yield of the municipal bond. The after-tax yield is calculated as the corporate bond rate * (1 - tax rate). Solving for the corporate bond rate: 6% = corporate bond rate * (1 - 0.40), corporate bond rate = 10%.

Question 10

Assume that Shavonne's marginal tax rate is 50% and her tax rate on dividends is 15%. If a corporate bond pays 10.2% interest, what dividend yield would a dividend-payingstock (with no growth potential) have to offer for Shavonne to be indifferent between the two investments from a cash-flow perspective?

Accepted Answer

The answer of Assume that Shavonne's marginal tax rate is...

Question 11

Assume that Bill's marginal tax rate is 30%. If corporate bonds pay 8% interest, what interest rate would a municipal bond have to offer for Bill to be indifferent between the two bonds?

Accepted Answer

The answer of Assume that Bill's marginal tax rate is...

Question 12

Which of the following may limit the conversion strategy?

Accepted Answer

Implicit taxes can limit the conversion strategy as they represent the reduced before-tax return on tax-favored investments, which can offset the benefits of lower explicit taxes.

Question 13

Assume that Will's marginal tax rate is 32% and his tax rate on dividends is 15%. If a dividend-paying stock (with no growth potential) pays a dividend yield of 8%, what interest rate must the corporate bond offer for Will to be indifferent between the two investments from a cash-flow perspective?

Accepted Answer

To find the interest rate that makes Will indifferent between a dividend-paying stock and a corporate bond, we need to set the after-tax dividend yield equal to the after-tax interest rate.

After-tax dividend yield = Dividend yield * (1 - tax rate on dividends) 
After-tax dividend yield = 0.08 * (1 - 0.15) = 0.068

After-tax interest rate = Interest rate * (1 - marginal tax rate) 
0.068 = Interest rate * (1 - 0.32) 
Interest rate = 0.1 or 10%

Therefore, the corporate bond must offer an interest rate of 10% for Will to be indifferent between the two investments from a cash-flow perspective.

Question 14

If Tom invests $60,000 in a taxable corporate bond that provides a 5 percent before-tax return, how much will Tom's investment be worth in either 8 or 20 years from now when the bond matures? Assume Tom's marginal tax rate is 35 percent.

Accepted Answer

The answer of If Tom invests $60,000 in a taxable...

Question 15

Assume that Javier is indifferent between investing in a city of El Paso bond that pays5% interest and a corporate bond that pays 6.25% interest. What is Javier's marginal tax rate?

Accepted Answer

The answer of Assume that Javier is indifferent between investing...

Question 16

Assume that Lavonia's marginal tax rate is 20%. If a city of Tampa bond pays 5% interest, what interest rate would a corporate bond have to offer for Lavonia to be indifferent between the two bonds?

Accepted Answer

The answer of Assume that Lavonia's marginal tax rate is...

Question 17

A taxpayer earning income in "cash" and not reporting it as taxable income is an example of:

Accepted Answer

Tax evasion refers to the illegal act of not reporting or under-reporting taxable income with the intention of evading taxes. In this scenario, the taxpayer is not reporting the cash income as taxable income, which is a clear example of tax evasion. Income shifting refers to the legal act of transferring income from a high tax rate entity to a low tax rate entity, while tax avoidance refers to the legal and strategic use of tax laws to minimize tax liability. Conversion is the act of changing the form of income to avoid taxes. None of these terms are appropriate for this scenario, making option D the correct choice.

Question 18

Assume that Jose is indifferent between investing in a corporate bond that pays 10% interest and a stock with no growth potential that pays an 8% dividend yield. Assume that the tax rate on dividends is 15%. What is Jose's marginal tax rate?

Accepted Answer

Since Jose is indifferent between the bond paying 10% and the stock paying 8% dividend yield, we can assume that his after-tax return on the stock investment is also 10%. We know that the tax rate on dividends is 15%, which means that the pre-tax dividend yield must be 8%/(1-15%) = 9.41%. If we assume that Jose's marginal tax rate is equal to the tax rate on dividends (15%), then his after-tax return on the stock investment would be 8%*(1-15%) = 6.8%, which is lower than the 10% return on the bond investment. If we assume a higher marginal tax rate, then the after-tax return on the stock investment would be even lower. Therefore, the best assumption is that Jose's marginal tax rate is equal to the tax rate on dividends, which is 15%.

The best choice is C.

Question 19

Which of the following is more likely to receive IRS scrutiny under the assignment of income doctrine?

Accepted Answer

The answer of Which of the following is more likely...

Question 20

The income shifting and timing strategies are examples of:

Accepted Answer

Income shifting and timing strategies are legal methods of tax avoidance. Tax evasion and illegal taxpayer strategies are illegal methods of avoiding taxes.

Quiz 3: Tax Planning Strategies and Related Limitations