Question

Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December, she received a $28,000 bill from her accountant for consulting services related to her small business. Reese can pay the $28,000 bill anytime before January 30 of next year without penalty. Assume Reese’s marginal tax rate is 32 percent this year and will be 37 percent next year, and that she can earn an after-tax rate of return of 12 percent on her investments.

a. What is the after-tax cost if she pays the $28,000 bill in December?

    

b. What is the after-tax cost if she pays the $28,000 bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.)

    

c. Based on requirements a and b, should Reese pay the $28,000 bill in December or January?

    

Answer 1

A. If she Pays $28000 bill in December:

Present value tax savings =

$28,000 tax deduction x 32 percent marginal tax rate =$. 8,960

After-tax cost = Pretax Cost -Present Value Tax Savings

=$28000 -$8960 = $19040

B. If she Pays $28000 bill in January:

Tax savings =$28000 tax deduction x 37 percent marginal tax rate =$10360 in tax savings in one year.

Present Value of Tax Savings =

$10360 x 0.893 (Discount Factor, 1Year, 12 percent)

= $9,251

After-tax cost = Pretax Cost -Present Value Tax Savings

= $28000 - $9251= $18749

C. Reese shall pay $28000 in January.Delaying her payment from December to January will decrease the present value of the cash outflow. Thus, there is a present value benefit associated with delaying her payment.