Question

Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $39,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Manny's marginal tax rate is 37 percent this year and 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 Manny sends his client the bill in December? After-tax income b. What is the after-tax income if Manny sends his client the bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.) After-tax income

Answer 1

Cash Method of Accounting:

In income tax there are two ways of accounting, one is cash accounting and other is accrual accounting.

As per Cash method the income is recognized or booked at the time of receipt irrespective of when it will be realized.

Part 1: Where Manny earns $39000 with tax rate of 37% and after tax rate of return of 4%:

a) Manny earns the income in December:

If Manny earns income in December of $39000 then after tax cost of income in moth of December is $ 24,570 [$39000*(1-.37)].

b) Manny raises the bill in January next year:

In such case with after tax rate of return of 4% and tax rate being the same of 37%, Manny shall raise the bill of $23,992.8 [39000*(1-.37) *1.04].

c) Based on above requirements which option is benefitting to Manny:

December shall be more profitable to Manny due to higher earnings.

Part 2: Where Manny provided legal services of $35000 with tax rate of 37% and after tax rate of return of 8%:

a) Manny earns the income in December:

If Manny earns the income in December with tax rate of 37%, the after tax cost of income to Manny shall be $ 22,050[$35000*(1-.37)].

b) Manny raises the bill in January next year:

In such case with after tax rate of return of 8% and tax rate being the same of 37%, Manny shall raise the bill of $23,814 [35000*(1-.37) *1.08].

c) Based on above requirements which option is benefitting to Manny:

January is the best option to Manny due to higher earnings.