Question

Happily Ever After Three years into the project, Corin and Lance have decided to get married. Because this union creates some difficult tax decisions, the couple is carefully considering their options. In particular, they are considering a risky tax strategy that often results in a tax audit. If their taxes are audited, it is certain that some “shortcuts” that Lance previously took will be noticed by the auditor, resulting in a substantial fine ($100,000). However, if there is no audit, then this tax strategy has the benefit of delaying the required reporting date of some income streams. The value of this benefit is $5000. Their accountant, Ms. Weiss, has been provided some valuable information. Out of 100 known cases where an audit took place, 40 of them involved the risky tax strategy that is being considered. In 500 known cases where no audit took place, 50 of them involved the risky tax strategy. Ms. Weiss also knows that, barring any additional information, tax audits have a probability of 0.01. If the couple decides not to use the risky tax strategy, then they expect to see no benefit or penalty.

i) Perform the appropriate analysis to help Ms. Weiss determine if the couple should use the tax strategy.

ii) Unbeknownst to Ms. Weiss, Corin and Lance have agreed that their interests can be accurately represented by the exponential utility function U(x) = 1 – e-x/100. Will this cause Ms. Weiss to give a different recommendation? Why or why not?

Answer 1

1. As per the case if their taxes are audited, because of some shortcuts used by Lance in the past, it may cost them penalty of $100000 and if no audit will take place then it may befit them by $5000. There is huge difference in the amount of benefit and penalty. Probability shows that in 100 cases every ¼ is audited through risky tax strategy and among 500 cases, only 50 involved risky tax strategy audit. 0.04% risk is involved if couple is involved in risky tax strategy and there is no benefit or penalty if couple not uses risky tax strategy. As the risk involved is low but if occurs the penalty amount is very high. Even penalty is far more higher than the benefits . I would suggest that couple should not go for risky tax strategy.
2. No, the exponential function will not cause Ms. Weiss to give a different recommendation. She would be saying the same thing that couple should not take such huge risk of $100000.