Question

American Corporation has two equal shareholders, Mr. Freedom and Brave Inc. In addition to their investments in American stock, both shareholders have made substantial loans to American. During the current year, American paid $140,000 interest each to Mr. Freedom and Brave Inc. Assume that American and Brave have 21 percent tax rates, and Mr. Freedom’s marginal tax rate on ordinary income is 37 percent.

1. Calculate American’s tax savings from deduction of these interest payments and their after-tax cost.
2. Calculate Brave’s tax cost and after-tax earnings from its receipt of interest income from American.
3. Calculate Mr. Freedom’s tax cost and after-tax earnings from his receipt of interest income from American.

5. Recalculate Brave’s tax cost and after-tax earnings assuming its receipt of interest from American is treated as a constructive dividend.
6. Recalculate Mr. Freedom’s tax cost and after-tax earnings assuming his receipt of interest from American is treated as a constructive dividend.

	a. Tax savings After-tax cost of interest b. Tax cost After-tax earnings c. Tax cost After-tax earnings e. Tax cost After-tax earnings f. Tax cost After-tax earnings

Answer 1

Answer(a)

Calculation of American’s tax savings from deduction of these interest payments and their after-tax cost.

Total cost of interest (Before tax)=140000

Less tax @21%= 29400

After tax cost of interest =110600

Hence tax savings=$29400

After tax cost of interest=$110600

Answer (b)

Calculation of Brave’s tax cost and after-tax earnings from its receipt of interest income from American.

Total interest income from American (Before tax) =140000

Less tax @21%= = 29400

After tax interest income   = 110600

Hence tax cost=$29400

After tax interest income=$110600

Answer (c)

Calculation of Mr. Freedom’s tax cost and after-tax earnings from his receipt of interest income from American.

Total interest income from American (Before tax) =140000

Less tax @21%= = 51800

After tax interest income   = 88200

Hence tax cost=$51800

After tax interest income=$88200

Answer (e)

Recalculation of Brave’s tax cost and after-tax earnings assuming its receipt of interest from American is treated as a constructive dividend.

In case of constructive dividend, Tax is paid first by corporation at corporate level and then at individual level by shareholder, Hence First Tax will be paid by American Corporation which will increase the revenue of the company resulting into same will be recovered from the individual shareholder, Hence Individual shareholder will be given net amount after tax, which again will be subject to taxation on which individual shareholder will pay tax at the rate applicable in his case depending upon his income.

Hence total tax will be as follow:

First tax @21% (to be charged by American Corporation)= 140000@21%=$29400

Second tax @21% (to be paid by Brave Inc) =140000@21%=$29400

Total tax cost for Brave Inc =$29400+$29400=$58800

Net after tax earnings =$140000-$58800=$81200

Answer (f)

Recalculation of Mr. Freedom’s tax cost and after-tax earnings assuming his receipt of interest from American is treated as a constructive dividend.

Interest income from American Corporation=$140000

Tax liability for American Corporation to be deducted from interest to be paid to Freedom=$140000*21%=$29400

Tax liability for Mr. Freedom= $140000@37%=$51800

Net earnings after tax = $140000-$29400-$51800 = $58800