Question

Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December, she received a $21,000 bill from her accountant for consulting services related to her small business. Reese can pay the $21,000 bill anytime before January 30 of next year without penalty. Assume Reese's marginal tax rate is 32 percent this year and 35 percent next year, and that she can earn an after-tax rate of return of 10 percent on her investments. a. What is the after-tax cost if she pays the $21,000 bill in December? After-tax cost b. What is the after-tax cost if she pays the $21,000 bill in January? Use Exhibit 3.1. (Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.) After-tax cost c. Should Reese pay the $21,000 bill in December or January? O December January

Answer 1

a. To pay $21,000 bill in December:

Tax saving, present value = $21,000 (tax deduction) 32% marginal tax rate = $6,720 After-tax cost = Pre-tax cost – Tax saving, present value = $21,000 - $6,720 = $14,280

b. To pay $21,000 bill in January:

Tax saving, after one year = $21,000 (tax deduction) X 35% marginal tax rate = $7,350 Tax saving, present value = Tax saving, after one year PVF for 1 year, 10% = $7,350 x 0.909 = $6,681 After-tax cost = Pre-tax cost – Tax saving, present value = $21,000 - $6,681 = $14,319

c. January

After-tax cost for January is more, accordingly, the bill for $21,000 should be paid in January.