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 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?

Answer 1

Answer:

Paying the $20,000 in December is the clear winner. Accelerating her payment from January to December will increase the present value of the cash outflow by a few days. Thus, there is a minor present value cost associated with accelerating her payment.

Explanation:

Option 1: Pay $20,000 bill in December:

$20,000 tax deduction x 40% 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 x 40% = $8,000

Present Value of Tax savings = $8,000 x .893 (Discount factor, 1 year, 12%) = $7, 144

After-tax cost = Pretax cost - Present value tax savings

= $20,000 - $7,144 = $12,856