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 9 percent on her investments. When should she pay the $20,000 bill this year or next?

She should pay in December

Explanation:

Assuming she pays in December, she can claim a 37% tax saving as it is an Expense and she will therefore pay the following Net of Tax,

= $20,000 * ( 1 - tax rate)

= 20,000 * ( 1 - 0.37)

= 20,000 * 0.63

= $12,600

Her total bill in December would be $12,600.

If she pays in January however then she would have lost 9% on the tax saving. Accounting for this would be,

The tax saving is

= $20,000 * 0.37

= $7,400

Discounting it to present day will be,

= 7,400 / (1 + r)

= 7,400 / 1 .09

= $6,788.99

Meaning that the amount she will effectively pay in January is,

= $20,000 - 6,788.99

= $13,211.01

Paying in December therefore saves her more.