Question

Hank, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December, he performed $28,000 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 11 percent on his investments.

a. What is the after-tax income if Hank sends his client the bill in December?

       

b. What is the after-tax income if Hank sends his client the bill in January?

       

  

c. Based on requirements a and b, should Hank send his client the bill in December or January?

       

• December

• January

Answer 1

Answer:

(a)

Present value of Tax Savings                          =   Amount of Bill x Marginal Tax rate                        =    $ 28,000 x 32%                        =    $ 8,960

After-tax Cost              = Pre-tax Cost (-) Present value of Tax Savings                =   $ 28,000 (-) $ 8,960              =   $ 19,040

After-tax Cost   = $ 19,040

(b)

Present value of Tax Savings                          =   Amount of Bill x Marginal Tax rate                        =    $ 28,000 x 37%                        =    $ 10,360

After-tax Cost              = Pre-tax Cost (-) [ Present value of Tax Savings x PVF ( 4%, 1 year )              =   $ 28,000 (-) [ $ 10,360 x 0.901)              =   $ 28,000 (-) $ 9,334.36              =    $ 18,665.64

After-tax Cost =    $ 18,665.64 (or) $ 18,666

(c )

After-tax Cost is low January when Hand send his bill, So, Hank should Send the bill in December

December