Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $44,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $44,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 9 percent on her investments.
a. What is the after-tax cost if Isabel pays the $44,000 bill in December?
b. What is the after-tax cost if Isabel pays the $44,000 bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.)
c. Based on requirements a and b, should Isabel pay the $44,000 bill in December or January?
December
January
A.
Pay $44,000 bill in December:
$44,000 tax deduction x 36 percent marginal tax rate = $6840 in present value tax savings.
After-tax cost=Pretax cost - Present value tax savings =$44000-$6840
=$37160
B.
Pay $44,000 bill in January:
$44,000 tax deduction x 36 percent marginal tax rate - $6840 in tax savings in one year.
Present value of tax Savings
After-tax cost
= $6840 x 0.917 (Discount Factor, 1 Year, 9percent)
= $6272
=Pretax cost Present value tax savings
=$44000 - $6272 = $37728.
C.
Paying the $44,000 in December is the clear winner. Accelerating her payment from January to December will increase the present value of the cash outflow by a few days. Thus, there is a minor present value cost associated with accelerating her payment.
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