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

a.	Tax savings	$29400
	After-tax cost of interest	$110600
b.	Tax cost	$29400
	After-tax earnings	$110600
c.	Tax cost	$51800
	After-tax earnings	$88200
e.	Tax cost	$10290
	After-tax earnings	$129710
f.	Tax cost	$21000
	After-tax earnings	$119000

Part A

Tax savings = 140000*21% = 29400

After tax cost of interest = 140000-29400 =$110600

Part B

Tax cost = 140000*21% = 29400

After tax earnings = 140000-29400 =$110600

Part C

Tax cost = 140000*37% = 51800

After tax earnings = 140000-51800 =$88200

Part E

Tax cost = 140000*(1-65%)*21% = 10290

After tax earnings = 140000-10290 =$129710

Part F

Tax cost = 140000*15% = 21000

After tax earnings = 140000-21000 =$119000