Question

During the year just ended, Shering Distributors, Inc., had pretax earnings from operations of $490,000. In addition, during the year it received $20,000 in income from interest on bonds it help in Zig Manufacturing and received $20,000 in income from dividends on its 5% common stock holding in Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries stock.

A. Calculate the firm's tax on its operating earnings only.

B. Find the tax and after-tax amount attributable to dividend and interest income.

b. Interest c. Dividend
Before-tax income $0 $0
Less exclusion 0 $0 Use the exclusion 70%
Taxable income $0 $0
Tax 40% $0 $0
After-tax amount $0
$0

â Compare, contrast, and discuss theâ after-tax amounts resulting from the interest income and dividend income calculated in parts b. and c. â(Select all the choices thatâ apply.) A. Theâ after-tax amount of dividendsâ received, $ 24 comma 165â, exceeds theâ after-tax amount ofâ interest, $ 21 comma 330â, due to the 50 % corporate dividend exclusion. B. Theâ after-tax amount of dividendsâ received, $ 21 comma 330â, exceeds theâ after-tax amount ofâ interest, $ 24 comma 165â, due to the 50 % corporate dividend exclusion. C. Since theâ after-tax amount of interest exceeds theâ after-tax amount ofâ dividends, this increases the attractiveness of stock investments by one corporation in another relative to bond investments. D. Since theâ after-tax amount of dividends exceeds theâ after-tax amount ofâ interest, this increases the attractiveness of stock investments by one corporation in another relative to bond investments.

Answer 1

(D).

Step-by-step explanation:

Shering's taxable income = Earnings before interest and tax(EBIT) + Interest income + Taxable Dividend Income

A. Tax on operating income only = $490000 × 40% = $196,000

Tax attributable to dividend and interest income = $516,000 × 40% less 490,000 × 40%

Tax attributable to dividend and interest income= $10,400

B. Interest $20,000

Dividend $20,000

Before tax income $490,000 + 20,000 + 20,000= $530,000

Taxable Income = $530,000 - Dividend excluded from taxation

Taxable Income= $530,000 - 70% of 20,000= $516,000

Tax at 40% on above = $516,000 × 40% = $206,400

After tax income= $516,000- 206,400= $ 309,600

In case of dividend, due to 70% exemption from taxation, only 30% of dividend is subject to tax i.e out of $20,000 receipts, only $6,000 is taxable, the tax on which is $2,400

Whereas in case of income from interest, the whole $20,000 is taxable at 40%. Tax on such income being $8,000

The net receipts in case of dividend thus would be, $20,000 - $2,400 = $17,600

Whereas in case of Interest, the after tax receipts would be, $20,000 - $8,000= $12,000

As can be seen, the correct option is (d) since the after tax amounts of dividends exceeds the after tax amount of interest, this increases the attractiveness of stock investments by one corporation in another relative to bond investments.

What needs to be noted though being, investment in stocks might appear favourable here, but such investment is also more riskier than investment in bonds which carry a fixed rate of interest and fixed term of principal repayment.