appendix3a - Web Appendix 3A The Federal Income Tax System...

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Appendix 3A The Federal Income Tax System Answers and Solutions 1 Web Appendix 3A The Federal Income Tax System Answers to Questions 3A-1 The interest paid by a corporation is deducted from its operating income to obtain its taxable income, but dividends paid are not deductible. The fact that interest is a deductible expense has a profound effect on the way businesses are financed our corporate tax system favors debt financing over equity financing. 3A-2 If the business were organized as a partnership or a proprietorship, its income could be taken out by the owners without being subject to double taxation. Also, if you expected to have losses for a few years while the company was getting started, if you were not incorporated, and if you had outside income, the business losses could be used to offset your other income and reduce your total tax bill. These factors would lead you to not incorporate the business. An alternative would be to organize as an S Corporation, if requirements are met. 3A-3 The appropriate tax rate depends on the owner’s situation. If the own er has substantial other income, then the major concern would be the business’s marginal contribution to taxes, so the marginal tax rate would be more relevant. Conversely, if there were no outside income, the average tax rate would be more relevant.
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2 Answers and Solutions Appendix 3A The Federal Income Tax System Solutions to Problems 3A-1 Married taxable income = $102,000; Federal taxes = ? Taxes = $8,000.00 + ($102,000 $58,100)0.25 = $8,000.00 + ($43,900)0.25 = $18,975.00. 3A-2 Corporate yield = 9%; T = 35%; AT yield = ? AT yield = 9%(1 T) = 9%(0.65) = 5.85%. 3A-3 Corporate bond yields 8%; Municipal bond yields 6%. bond taxable on tax yield - pre Equivalent = ) T (1 muni on Yield 8% = ) T 1 ( % 6 0.08 0.08T = 0.06 -0.08T = -0.02 T = 25%. 3A-4 Compare the after-tax returns of the two investments: Corporate bond = 0.09(1 0.35) = 0.0585 = 5.85%. Municipal bond = 0.07 = 7%; therefore, choose the municipal bond over the corporate bond.
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