Question 1

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

Jose is indifferent between the two investments, meaning the after-tax return on the bond equals the after-tax return on the stock. The after-tax return on the bond is 10% * (1 - marginal tax rate). The after-tax return on the stock is 8% * (1 - 0.15). Setting these equal gives 10% * (1 - marginal tax rate) = 8% * 0.85. Solving for the marginal tax rate gives 32%.

Question 2

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?

Accepted Answer

Since Will's tax rate on dividends is 15%, his after-tax return on dividends will be 8% × (1 - 15%) = 6.8%. In order for Will to be indifferent between the dividend-paying stock and the corporate bond, the interest rate on the bond must also provide an after-tax return of 6.8%. Given Will's marginal tax rate of 32%, the pre-tax return on the bond that would yield 6.8% after taxes would be 10% (i.e. 10% × (1 - 32%) = 6.8%). Therefore, Choice C is the correct answer.

Question 3

Jason's employer pays year-end bonuses each year on December 31. Jason, a cash basis taxpayer, would prefer to not pay tax on his bonus this year (and actually would prefer his daughter to pay tax on the bonus). So, he leaves town on December 31, 2014 and has his daughter, Julie, pick up his check on January 2nd, 2015. Who reports the income and when?

Accepted Answer

As a cash basis taxpayer, Jason must report the income in the year it is made available to him, which is 2014, regardless of when he physically receives the check.

Question 4

A common income shifting strategy is to:

Accepted Answer

The answer of A common income shifting strategy is to:
...

Question 5

Assume that Marsha is indifferent between investing in a city of Destin bond that pays 6% 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 6

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 effectively only receives 75% of the interest from corporate bonds after taxes. Therefore, a municipal bond would have to offer an interest rate such that 75% of the interest earned is equal to the 10% interest from the corporate bond. Solving for this, we get:
0.75x = 0.10
x = 0.10/0.75 = 0.1333 or 13.33%
Thus, a municipal bond would have to offer at least 13.33% interest for Larry to be indifferent between the two bonds. Since no answer choice is exactly 13.33%, the closest answer choice is D, 7.5%. However, it is important to note that this is not the exact answer and there may be some degree of approximation involved.

Question 7

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

Accepted Answer

Investing in tax-exempt municipal bonds is a conversion strategy because it converts taxable income into tax-exempt income, effectively reducing the investor's tax liability. The other options are not examples of conversion strategies.

Question 8

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 of the corporate bond is calculated as the interest rate times (1 - tax rate). So, 6% = x * (1 - 0.40). Solving for x gives x = 10%.

Question 9

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

Accepted Answer

The assignment of income doctrine states that income cannot be assigned to someone in a lower tax bracket to avoid paying income tax. A parent employing their child in the family business may receive IRS scrutiny as the parent may be attempting to shift income to the child who may be in a lower tax bracket.

Question 10

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 11

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-paying stock (with no growth potential) have to offer for Shavonne to be indifferent between the two investments?

Accepted Answer

The after-tax return on the corporate bond is 10.2% * (1 - 50%) = 5.1%. The after-tax return on the dividend-paying stock is the dividend yield * (1 - 15%). For Shavonne to be indifferent between the two investments, the dividend yield must be 5.1% / (1 - 15%) = 6%.

Question 12

A taxpayer instructing her son to collect rent checks for the taxpayer's property and to report this as taxable income on the son's tax return violates which doctrine?

Accepted Answer

The assignment of income doctrine states that income must be taxed to the person who earns it or generates it rather than assigning it to someone else. If a taxpayer instructs someone else to collect rent checks and report it on their tax return, they are violating this doctrine as the rental income should be reported on the taxpayer's tax return as it is their property generating the income. This is not a violation of constructive receipt or step-transaction doctrine. There is no such doctrine as an implicit tax doctrine.

Question 13

Assume that Javier is indifferent between investing in a city of El Paso bond that pays 5% 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 14

Which of the following is needed to implement the income shifting strategy?

Accepted Answer

The income shifting strategy involves shifting income from a taxpayer with a high tax rate to one with a lower tax rate, in order to reduce overall taxes paid. Therefore, taxpayers with varying tax rates are needed to implement this strategy.

Question 15

A taxpayer paying his 10 year old daughter $50,000 a year for consulting likely violates which doctrine?

Accepted Answer

The substance-over-form doctrine is violated here as the arrangement lacks economic reality; a 10-year-old is unlikely to provide consulting services worth $50,000, indicating the form of the transaction does not reflect its true substance.

Question 16

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?

Accepted Answer

Since Keisha's marginal tax rate is 40%, she will pay 40% tax on the interest earned from the bond. Hence, her after-tax return from the bond will be 7.65%*(1-40%)=4.59%. On the other hand, since her tax rate on dividends is only 15%, she will pay only 15% tax on the dividends earned from the stock. To be indifferent between the two investments, the dividend yield on the stock should be such that her after-tax return from the stock is also 4.59%. Therefore, dividend yield=4.59%/(1-15%)=5.4%. Since a stock with no growth potential is expected to pay out its entire earnings as dividends, the dividend yield equals the earnings yield. Hence, the stock should offer an earnings yield of 5.4%, which is closest to option C, 9%. Option C is, therefore, the correct answer.

Question 17

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, what interest rate would a municipal bond have to offer for Lucas to be indifferent between the two investments?

Accepted Answer

Since Lucas' tax rate on dividends is 15%, his after-tax dividend yield is 8% * (1 - 0.15) = 6.8%. For Lucas to be indifferent between the dividend-paying stock and the municipal bond, the bond would have to offer a yield that is also 6.8% (or higher) after taxes. Lucas' marginal tax rate is 30%, so he would save 30% in taxes on the interest income from the municipal bond. Therefore, the taxable yield of the bond needs to be 6.8% / (1 - 0.3) = 9.71%. Since municipal bonds typically offer a lower yield than corporate bonds due to their tax-exempt status, it is likely that Lucas would not be able to find a municipal bond that offers a 9.71% yield, making the dividend-paying stock the best choice for him.

Question 18

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 19

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

Accepted Answer

Paying an owner a salary is an example of income shifting strategy as it allows the corporation to deduct the salary as a business expense, which reduces its taxable income, while the owner will pay income tax on the salary at their individual tax rate.

Question 20

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.

Quiz 3: Tax Planning Strategies and Related Limitations