A Theory of Tax Planning

Abstract

I model a tax planning setting where the tax authority decides whether to challenge a taxpayer’s deduction with a limited scope audit, and the taxpayer must balance the probability of a rejected deduction against the size of an aggressive claim. Multiple interpretations are possible given the language-based classifications found in the tax code, and while the underlying facts are freely available (not hidden from the tax authority), the tax authority must still come to a judgment as to whether a transaction has been properly classified. Accordingly, as long as the probability of denying the claim is less than 50%, the doctrine of substantial authority protects the taxpayer from the assessment of tax penalties. The model describes a possible perception of ‘undersheltering’ where taxpayers with moderate unchallenged claims coexist with (potentially similar) taxpayers who make aggressive challenged ones. In contrast to models of tax evasion, the model describes how the tax authority’s net tax collections may increase under a policy of fewer challenges.

Keywords: Tax planning; Substantial authority; Shadow standard; FIN 48.