Nicole is a calendar-year taxpayer who accounts for her business using the cash method. On average, Nicole sends out bills for about $12,000 of her services at the first of each month. The bills are due by the end of the month, and typically 70 per cent of the bills are paid on time and 98 per cent are paid within 60 days.
A. Suppose that Nicole is expecting a 2 per cent reduction in her marginal tax rate next year. Ignoring the time value of money, estimate the tax savings for Nicole if she postpones mailing of bills for December until January 1 of next year.
B. Describe how the time value of money affects your calculations.
C. Would this tax savings strategy create any additional business risks? Explain.
The correct answer and explanation is :
A. Tax Savings Estimate for Nicole
Nicole uses the cash method of accounting, meaning she recognizes income when cash is actually received rather than when it is earned. The strategy in question involves postponing the mailing of bills for December until January, which would push the income into the next year.
The amount of the bills Nicole sends out each month is $12,000. Typically, 70% of the bills are paid on time, and 98% are paid within 60 days. By postponing the mailing of bills, Nicole would effectively delay the recognition of income for one month, which would shift income from this year to the next year.
If Nicole’s tax rate is expected to decrease by 2% next year, the tax savings would result from deferring income until the new year when her marginal tax rate is lower.
For the income she is deferring:
- Total amount of bills to be mailed in December = $12,000.
- The tax rate reduction next year is 2%, so the savings per dollar of deferred income is 2% of her marginal tax rate.
Let’s assume Nicole’s current tax rate is T. The tax savings from deferring $12,000 of income would be calculated as:
Tax Savings = $12,000 * 2% = $240.
Therefore, by postponing the mailing of bills, Nicole could save $240 in taxes.
B. Time Value of Money
The time value of money (TVM) suggests that money received today is worth more than the same amount received in the future because of its potential earning power. Ignoring the time value of money in this case means that we’re treating the tax savings as if they’re equivalent whether they occur today or in the future, which is a simplified approach. In a more sophisticated analysis, if Nicole had to wait until the next year to benefit from the tax savings, she might not receive the full value of the $240 due to inflation or the opportunity to invest the money this year. This would lower the overall benefit, especially if the delay is significant.
C. Business Risks from This Strategy
Delaying the mailing of bills could introduce a few business risks:
- Cash Flow Disruption: By deferring income, Nicole would delay her cash flow, which could impact her ability to meet operating expenses or invest in the business.
- Customer Relationships: Delaying bills may affect customer relations, as clients might not receive their invoices in a timely manner, which could lead to confusion or frustration. This might also impact the payment behavior of some clients.
- Tax Risks: The IRS generally expects taxpayers to recognize income in the period it is earned. If the IRS scrutinizes Nicole’s deferral strategy, they might deem it as a form of tax avoidance, potentially resulting in penalties or the denial of the tax benefit.
In conclusion, while the tax savings from deferring the bills are real, the strategy introduces potential business risks that need to be weighed carefully.