Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sol

Question

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $70,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $70,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 20 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 $70,000 bill in December?

  

b. What is the after-tax cost if Isabel pays the $70,000 bill in January? Use Exhibit 3.1.

c. Based on requirements a and b, should Isabel pay the $70,000 bill in December or January?

December

January

COURSE :federal taxe and procedure

Explanation / Answer

ANSWER:

A) PAY $70,000 in december.

present value in tax savings = tax deduction * marginal tax rate

pv in tax savings = $70,000 * 20% = $14,000

after tax cost = pre tax cost - present value tax savings

after tax cost = $70,000 - $14,000 = $56,000

b) pay $70,000 bill in january

tax savings in 1 year = tax deduction * marginal tax rate

tax savings in 1 year = $70,000 * 20% = $14,000

present value of tax savings = tax savings in 1 year(p/f,i,n)

n = 1 year and i = 9%

present value of tax savings = 14,000(p/f,9%,1)

pv of tax savings = 14,000 * 0.9174 = $12,843.6

after tax cost = pre tax cost - pv in tax savings

after tax cost = $70,000 - $12,843.6 = $57,156.4

c) paying the tax in december is better as after tax cost in december is better then in january.

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