Question

Hank, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December, he performed $30,000 of legal services for a client. Hank typically requires his clients to pay his bills immediately upon receipt. Assume his marginal tax rate is 32 percent this year and will be 37 percent next year, and that he can earn an after-tax rate of return of 4 percent on his investments. a. What is the after-tax income if Hank sends his client the bill in December? After-tax income b. What is the after-tax income if Hank sends his client the bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.) After-tax income c. Based on requirements a and b, should Hank send his client the bill in December or January? O December O January

Answer 1

Requirement 1: Send the $30,000 bill in December:

$30,000 taxable income x 32 percent marginal tax rate = $9,600 in present value tax

After-tax income = Pretax income – Present Value Tax

= $30,000 – $9,600 = $20,400.

Requirement 2: Send the $30,000 bill in January:

$30,000 taxable income x 37 percent marginal tax rate = $11,100 in tax in one year.

Present Value of Tax = $11,100 x .962 (Discount Factor, 1 Year, 4 percent)

= $10,678.

After-tax income = Pretax income – Present Value Tax

= $30,000 – $10,678 = $19,322.

Sending the $30,000 bill in December is the clear winner. Accelerating the invoice will also increase the present value of the cash inflow slightly. Thus, there is a minor present value benefit associated with accelerating the income.