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 $120,000 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 Tax cost After-tax earnings Tax cost After-tax earnings Tax cost After-tax earnings Tax cost After-tax earnings
   

Answer 1

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

Tax savings	120000
After-tax cost of interest	25200
120000*21%

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

Tax Cost	120000
After-tax earnings	94800
120000*(100%-21%)

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

Ideally, the income of Mr. Freedom shall be taxed on progressive basis. In absence of tax slabs given, we are calculating on flat basis.

Tax Cost	120000
After-tax earnings	75600
120000*(100%-37%)

In case of constructive dividend paid, it will still be taxable in the hands of shareholder as per income of the shareholder.