Question

a. Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel has plenty of cash in the bank to cover the bill and can pay the $20,000 bill any time before January 5 of next year without penalty. Assume her marginal tax rate is 30 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

b. What if Isabel has a current MTR of 20 percent but expects a MTR of 40 percent next year?

Answer 1

a) Pay $20000 in december

$20000 will be tax deductible

So tax saving will be 20000 x 30% =6000

After tax cost would be 20000-6000 = 14000

Pay in january

Tax saving will be $6000 only

since it will be next year we will find its present value @ 12% for 1 year

Present value fctor is = 1 / (1+.12)1 = 0.893

Present value = $6000 x 0.893 =5358

After tax cost 20000-5350 = 14642

Since after tax cost is less in december isabel shoud pay in december

b) If current tax rate is 20% and next year 40 %

Pay in december

Tax saving 20000 x 20% = 4000

After tax cost = 20000-4000 =16000

Pay in january

Tax saving 20000 x40% = 8000

Present value of savings = 8000 x 0.893 =7144

After tax cost = 20000-7144 = 12856

Since after tax cost is less in january .Isabel should pay bill in january