Multiple Years

This lesson covers decisions where a person pays income tax to a single jurisdiction but some incremental receipts or payments occur in later years. To determine the MTR, build a simple model or equation that appropriately considers present value concepts. This lesson illustrates these concepts using examples in which taxpayers: (1) receive current income but pay tax later and (2) pay tax now on income not yet received.


Income Now, Tax Later

As defined in the “Basic Tax Rate Concepts” lesson, the MTR associated with a particular decision equals:

(1)

When taxpayers receive income (even if restricted in some manner) but pay tax in later years, present value concepts affect the MTR. In Equation 1, discounting the numerator's tax lowers the MTR vis-à-vis paying tax immediately. Many instances of deferred tax involve employment income that individuals contribute to qualified retirement plans.

Example 1:

Aaron’s current income places him well into the 35% tax bracket. This year, his employer contributes $10,000 to a 401(k) retirement plan on Aaron’s behalf. The $10,000 represents employment income not taxable until later withdrawn. Assume Aaron plans to retire in ten years and will withdraw his current contribution of $10,000 at that time. Also, he expects a top tax bracket of only 25% after retirement (either with or without the planned $10,000 withdrawal), and his applicable discount rate is 8%, so he will divide the $2,500 in the numerator by the discount factor. Aaron determines the MTR related to this decision as follows:

 

 


  This 11.6% MTR compares favorably with the 35% rate otherwise applied to the $10,000 if the employer had increased Aaron's salary instead of making a 401(k) contribution. Of course, investment earnings on the $10,000 contribution also avoid tax until withdrawn from the plan, but the formula emphasizes the MTR applicable only to the contribution amount.

This example illustrates a common theme underlying many tax strategies—shifting tax liabilities to other years. Shifting taxes to later years tends to lower the MTR because such taxes enter the MTR formula at their present value. But the MTR declines even further if you assume lower statutory rates in post-retirement years. On the other hand, expected increases in a person's taxable income or anticipated Congressional action to raise tax rates might prompt a tax planner to shift tax liabilities to earlier years.

In addition to deferred tax on contributions to retirement plans, incremental income in the presence of overall business losses may require present value analysis when computing MTRs. We often assume enterprises show consistent profit from one year to the next. However, when net operating losses (NOLs) occur, the downward effect on MTRs can be significant. At the same time, you should not conclude the MTR on incremental income is zero or necessarily low simply because the company has losses.

Example 2:

In its first taxable year, Duncan Corporation expects an NOL of $4 million. However, an unexpected market opportunity provides $1 million incremental income, reducing the NOL to $3 million. Duncan projects similar losses for the next two years; however, the company expects at least $30 million profit in the fourth and succeeding years. The NOL deduction carried to the fourth year is $1 million smaller because of the incremental income in year one. That is, the $1 million incremental income (via the smaller NOL carryforward) increases the income tax Duncan expects to pay in three years. Assuming a 7% discount rate, 1.07 to the third power becomes the divisor in the numerator. So, the MTR associated with the current year's incremental income is determined as follows:

 

 



Tax Now, Income Later

Under §453, installment sales involve property dispositions in which sellers receive at least one payment after the year of sale. Generally, sellers do not recognize gain from installment sales except as they receive payments. However, installment sales of inventory and dealer dispositions do not qualify for gain deferral and, thus, result in current tax. In effect, these sales result in current tax even though the seller does not receive income until later.

Example 3:

Brevard, Inc. manufactures and sells heavy construction equipment. The terms of one sale require no money down and the full $1 million price in two years. Since the equipment cost $700,000 to manufacture, the income related to this sale is $300,000. For tax purposes, the company recognizes the entire $300,000 gain immediately even though it does not receive payment for two years. Assuming a 6.6% discount rate and taxable income before considering this sale of $4 million, the MTR calculation appears below:

 

 


  In contrast to Example 1, discounting the denominator causes the MTR to increase vis-à-vis the 34% tax rate otherwise applicable. (Of course, you might argue the $300,000 income should not be discounted since Brevard earned it when the sale occurred, as evidenced by the installment note receivable. Under that view, the MTR would be 34%.)

You might analyze the following transactions in a similar manner:

(1)

Under §83, someone receiving restricted property for performing services generally recognizes no gross income until the property becomes transferable or a substantial risk of forfeiture no longer exists. Until the restrictions dissipate, income does not materialize since the payer’s bankruptcy, the recipient’s separation from service, or a host of other events might prevent the recipient from fully possessing and enjoying the property. Nonetheless, the recipient can elect to pay tax immediately on the current value of the restricted property. If elected, the recipient pays tax now related to income that he expects will materialize in the future.

(2)

Except for home construction and certain realty agreements, §460 requires taxpayers to report gross income under long-term contracts using the percentage of completion method. Thus, contracts withholding payments until performance of all contractual terms (but not involving one of the noted exceptions) involve periodic tax payments for the percentage of gross income recognized even though the service performer receives no income until later.

This lesson explains how to compute MTRs when a single jurisdiction taxes a person receiving income or paying tax over two or more years. The next lesson involves MTRs when a person pays tax to multiple jurisdictions. However, before proceeding to the “Multiple Jurisdictions” lesson, please take the self-tests covering multiple years to assure your understanding. Also, please complete the “Short Exit Questionnaire” before leaving the site.