Question

In: Accounting

Tom can choose when he is to receive $100,000 of fully taxable bonus. If he receives...

Tom can choose when he is to receive $100,000 of fully taxable bonus. If he receives the bonus at the end of 2016, his bonus will be $100,000. If he postpones receipt of the bonus until the end of 2017, the amount will be $110,000. If Tom receives the bonus at the end of 2016, he can invest the proceeds with a pre-tax return of 10% over the next year.

If the marginal tax rate of Tom is 31% in 2016 and 2017, when should he elect to receive the bonus?

At what pre-tax rate of return will Tom be indifferent to receiving the bonus in the alternative years?

If the marginal tax rate of Tom increases to 35% in 2017, when should he elect to receive the bonus?

What would the tax rate need to be in 2017 to make Tom indifferent to the two options?

Expert Solution

1. To decide when to receive bonus

Particulars	2016	2017
Bonus received	100,000	110,000
Less: Tax @ 31%	31,000	34,100
Post tax amount received (A)	69,000	75,900
Proceeds of 2016 reinvested @10%	6,900	0
Tax on amount reinvested @ 31%	2,139	0
Post tax amount received from reinvestment (B)	4,761	0
Total cash receipts (A+B)	73,761	75,900

Tom should elect to receive bonus in 2017

2.Pre-tax rate of return

Amount of bonus received if elected to received in 2017 = 75,900

Amount of bonus received if elected to received in 2016 = 69,000

Difference in amount = 6,900

Amount of bonus to be reinvested to earn post tax return of 6,900 = 69,000

Post tax return rate = 6,900/69,000*100 = 10%

Pre tax return - 31%* Pre tax return = 6,900

Pre tax retuen = 10,000

Pre tax return rate = 10,000/69,000*100= 14.49%

3. To decide when to receive bonus

Particulars	2016	2017
Bonus received	100,000	110,000
Less: Tax @ 31% for 2016 and 35% for 2017	31,000	38,500
Post tax amount received (A)	69,000	71,500
Proceeds of 2016 reinvested @10%	6,900	0
Tax on amount reinvested @ 35%	2,415	0
Post tax amount received from reinvestment (B)	4,485	0
Total cash receipts (A+B)	73,485	71,500

Tom should elect to receive bonus in 2016

4. Tax rate in 2017

Let tax rate be x%

69,000+(6,900 - x% *6,900) = 110,000- x% *110,000

x% *110,000 - x% *6,900 = 110,000-69,000-6,900

103,100 *x% = 34,100

x% =34,100/103,100

x=33.07%

tax rate in 2017 = 33.07%

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