Question

Reese, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business.

Reese can pay the $20,000 bill any time before January 30 of next year without penalty. Assume Reese's marginal tax rate is 30 percent this year and will be 40 percent next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

Answer 1

Reese should pay the $20,000 bill this year to take advantage of her lower marginal tax rate of 30% compared to the 40% she will face next year, thus minimizing her tax liability despite a potential after-tax return of 12% on her investments.

Step-by-step explanation:

Reese should consider paying the $20,000 bill this year because her marginal tax rate is lower (30% compared to next year's 40%). If she pays this year, she'll save on taxes, effectively lowering her cost. If Reese postpones the payment until next year, she will incur a higher tax cost due to the increased marginal tax rate. Even after considering the potential after-tax return of 12% on her investments, the tax rate differential is significant enough to warrant paying the bill in the current tax year. This decision focuses on minimizing tax liability and maximizing resources. By paying this year, Reese not only reduces her taxable income but also avoids the higher tax rate she will face next year.