Question

Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $39,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Manny’s marginal tax rate is 40 percent this year and next year, and that he can earn an after-tax rate of return of 4 percent on his investments.

(a) What is the after-tax income if Manny sends his client the bill in December?
(b) What is the after-tax income if Manny sends his client the bill in January? Use Exhibit 3.1. (Round your intermediate calculations and final answer to the nearest whole dollar amount.)
(c) Based on requirements (a) and (b), should Manny send his client the bill in December or January?

Answer 1

Task a:

Answer is $23,400.

Task b:

The answer is $24,008.

Task c:

The answer is January.

Step-by-step explanation:

(a) What is the after-tax income if Manny sends his client the bill in December?

Step 1:

Calculate the present value tax saving:

Present value tax saving = Amount × Marginal tax rate

Present value tax saving = $39,000 × 40%

Present value tax saving = $15,600

Step 2:

Calculation of after tax saving:

After-tax cost = Pre-tax cost - Present value tax

After-tax cost = $39,000 - $15,600

After-tax cost = $23,400

The amount that Manny receives if the bill is sent in December is $23,400.

(b) What is the after-tax income if Manny sends his client the bill in January?

Step 1:

Calculation of present value tax saving:

Present value tax saving = Amount × Marginal tax rate

Present value tax saving = $39,000 × 40%

Present value tax saving = $15,600

Step 2:

Calculation of discount factor:

Present value =
`(future value)/((1+r)^(n) )`

Present value =
`(1)/((1+0.04)^(1) )`

Present value = 0.961

Step 3:

Calculation of present value of tax saving:

Present value of tax saving = Amount × tax saving

Present value of tax saving = $15,600 × 0.961

Present value of tax saving = $14,992

Step 4

After tax cost = Pre-tax cost - Present value tax rate

After tax cost = $39,000 - $14,992

After tax cost = $24,008

The amount that Manny receives if the bill is sent in January is $24,008.

(c) Based on requirements (a) and (b), should Manny send his client the bill in December or January?

Conclusion:

Amount Manny can receive if sends bill in December = $23,400

Amount Manny can receive if sends bill in January = $24,008

Since, Manny can receive higher amount if sends bill in January, therefore, it is recommended to send the bill in Janaury, NOT December.