Question

American Corporation has two equal shareholders, Mr. Freedom and Brave Inc. In addition to their investments in American stock, both shareholders have made substantial loans to American. During the current year, American paid $250,000 interest each to Mr. Freedom and Brave Inc. Assume that American and Brave have 21 percent tax rates, and Mr. Freedom’s marginal tax rate on ordinary income is 37 percent.

a. Calculate American’s tax savings from deduction of these interest payments and their after-tax cost.

b. Calculate Brave’s tax cost and after-tax earnings from its receipt of interest income from American.

c. Calculate Mr. Freedom’s tax cost and after-tax earnings from his receipt of interest income from American.

d. Recalculate Brave’s tax cost and after-tax earnings assuming its receipt of interest from American is treated as a constructive dividend.

e. Recalculate Mr. Freedom’s tax cost and after-tax earnings assuming his receipt of interest from American is treated as a constructive dividend.

Answer 1

Interest paid by American corporation = 250000*2 = $ 500000

Tax Rates:

American Corporation = 21% , Brave Inc = 21% , Mr Freedom = 37%

A) Interest Paid = 500000

Tax Saving @ 21% = 500000 * 21% = 105000

After tax Cost = Total Interest paid - Tax saving

= 500000 - 105000

= $ 395000

B) Brave Inc Interest income = $250000

Tax Cost @ 21% = 250000*21% = 52500

After tax savings = Interest Income - Tax cost

= 250000 - 52500

= $ 197500

C) Interest Income = $ 250000

Tax Cost @ 37% = 250000 * 37%

= 92500

After Tax Interest Saving = 250000 - 92500

= $ 157500

D) Constructive dividend is a payment to shareholder that is not classified as a distribution to the participant but which is classified later as dividend.

Constructive dividend is not allowed as expense to the company, so there is no tax saving to the company. But it is taxable in the hand of shareholder. there is no tax benefit to the shareholders.

So in the given case Interest received as constructive dividend to Brave Inc & Mr. Freedom remaims taxable. So Answer of (D) & (E) will remain same as of (B) & (C)