Question

Isabel, 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. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 8 percent on her investments. Required: What is the after-tax cost if Isabel pays the $20,000 bill in December? What is the after-tax cost if Isabel pays the $20,000 bill in January? Use Exhibit 3.1. Note: Round your answer to the nearest whole dollar amount. Based on requirements a and b, should Isabel pay the $20,000 bill in December or January?

Answer 1

If Isabel pays the $20,000 bill in December, her after-tax cost would be $12,600 ($20,000 x 0.63). This is because she can deduct the expense on her current year tax return, reducing her taxable income by $20,000 and saving her $7,400 in taxes ($20,000 x 0.37).

If Isabel pays the $20,000 bill in January, her after-tax cost would be $12,740 ($20,000 x 0.638). This is because she would not be able to deduct the expense until the following year, so she would not receive the tax savings until then.

Based on these calculations, Isabel should pay the $20,000 bill in December to minimize her after-tax cost.