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 $100,000 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.

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

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

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

e. Recalculate Brave’s tax cost and after-tax earnings assuming its receipt of interest from American is treated as a constructive dividend.

f. 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 $ $ $ $ $ $ 42,000 158,000 21,000 79,000 37,000 63,000 $ $ 20,000 80,000

Please help find e.

Answer 1

It is assumed that Brave Inc who is shareholder is "c" corporation. The dividend received by C corporation is subject to dividend received deduction. When shareholder holding more than 20% shares would get 80% deduction.

Hence :

Tax Cost : 4,200 (100000-80000)*21%

After Tax earning : 95,800