Chapter 3
Tax Planning Strategies and Related Limitations

SOLUTIONS MANUAL

Problems

[LO2, LO3 PLANNING] 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 40 percent this year and 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?

Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in present value tax savings.

After-tax cost = Pretax Cost – Present Value Tax Savings

= $20,000 – $8,000 = $12,000

Option 2: Pay $20,000 bill in January:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax savings in one year.

Present Value of Tax Savings = $8,000 x .893 (Discount Factor, 1 Year, 12 percent)

= $7,144

After-tax cost = Pretax Cost – Present Value Tax Savings

= $20,000 – $7,144 = $12,856

Paying the $20,000 in December is the clear winner.

[LO2, LO3 PLANNING] Using the facts from the previous problem, how would your answer change if Isabel’s after-tax rate of return were 8 percent?

Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in present value tax savings.

After-tax cost = Pretax Cost – Present Value Tax Savings

= $20,000 – $8,000 = $12,000

Option 2: Pay $20,000 bill in January:
$20,000 tax deduction x 40 percent marginal tax rate = $8,000 in tax savings in one year.

Present Value of Tax Savings = $8,000 x .926 (Discount Factor, 1 Year, 8 percent)

= $7,408

After-tax cost = Pretax Cost –