ATC 10-7 Ethical Dilemma: I Don’t Want to Pay Taxes
Dana Harbert recently launched a highly successful small business. In fact, the business had expanded so quickly that she could no longer sustain its operations by using her personal resources. She required additional capital but had no more personal funds to invest. A friend, Gene Watson, offered to invest $100,000 in the business. Harbert projected that with Watson’s investment, the company could boost revenue by $40,000, while operating expenses would only rise by 10 percent. Harbert and Watson agreed that Watson’s investment would entitle him to a cash dividend equal to 20 percent of net income.
Below are forecasted financial statements with and without Watson’s investment. (Assume all transactions involving revenue, expenses, and dividends are cash transactions.)
| Financial Statements | Forecast 1 without Watson’s Investment | Forecast 2 with Watson’s Investment |
|---|---|---|
| Income Statements | ||
| Revenue | $120,000 | $160,000 |
| Operating expenses | $(70,000) | $(77,000) |
| Income before interest and taxes | $50,000 | $83,000 |
| Income tax expense (effective tax rate is 30%) | $(15,000) | $(24,900) |
| Net income | $35,000 | $58,100 |
| Statements of Changes in Stockholders’ Equity | ||
| Beginning retained earnings | $15,000 | $15,000 |
| Plus: Net income | $35,000 | $58,100 |
| Less: Dividend to Watson (20% of $58,100) | 0 | $(11,620) |
| Ending retained earnings | $50,000 | $61,480 |
| Balance Sheets | ||
| Assets | $400,000 | $511,480 |
| Liabilities | $0 | $0 |
| Equity | ||
| Common stock | $350,000 | $450,000 |
| Retained earnings | $50,000 | $61,480 |
| Total liabilities and equity | $400,000 | $511,480 |
The asset balance in Forecast 1 is calculated as the beginning balance of $365,000 plus net income of $35,000. The asset balance in Forecast 2 is computed as the beginning balance of $365,000, plus the $100,000 cash investment, plus net income of $58,100, less the $11,620 dividend. Alternatively, total assets can be derived by determining the amount of total claims (i.e., total assets = total claims).
Harbert informs Watson that there would be a $3,486 tax advantage associated with debt financing. She suggests that if Watson agrees to become a creditor instead of an owner, she could pay him an additional $697.20 (20 percent of the tax advantage). Watson responds by saying that he is not interested in managing the business, but he wants an ownership interest to ensure that he receives 20 percent of the business's profits. Harbert proposes that they enter into a formal agreement in which Watson would receive 11.62 percent annual interest on his $100,000 loan to the business, to be used for income tax reporting. Additionally, Harbert says that she is willing to establish a private agreement to pay Watson a personal check for any additional amount required to ensure his total return equals 20 percent of all profits, plus the $697.20 bonus for his share of the tax advantage. Harbert says, “It’s just like ownership. The only difference is that we call it debt for the IRS. If they want to have some silly rule that says if you call it debt, you get a tax break, then we are foolish if we don’t call it debt. I will call it anything they want, just as long as I don’t have to pay taxes on it.”
Required:
a. Construct a third set of forecasted financial statements (Forecast 3) at 11.62 percent annual interest, assuming Watson is treated as a creditor (he loans the business $100,000).
b. Verify the tax advantage of debt financing by comparing the balances of the Retained Earnings account in Forecast 2 and Forecast 3.
c. If you were Watson, would you permit Harbert to classify the equity transaction as debt to provide a higher return to the business and to you?
d. Comment on the ethical implications of misnaming a financing activity for the sole purpose of reducing income taxes.
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