Sophie is the sole shareholder and president of Green Corpor

Sophie is the sole shareholder and president of Green Corporation. She feels that she can justify at least a $200,000 bonus this year because of her performance. However, rather than a bonus in the form of a salary, she plans to have Green pay her a $200,000 dividend. She believes this is preferable because it will be taxed at only 15% (her marginal rate is 35%). Her CPA suggests a $300,000 bonus in lieu of the $200,000 (Green Corporation is in the 34% tax bracket). Should Sophie take the $200,000 dividend or the $300,000 bonus? Support your answer by computing the after-tax cost (benefit) of the two alternatives to Green and to Sophie.

Specifically, show the following:

a. Sophie’s after tax benefit for the bonus versus the dividend.

b. Green’s after tax cost of the bonus versus the dividend.

c. Which is better for Sophie, which is better for Green?

Solution

Part A

Sophie’s after-tax benefit for the bonus is $195000 [$300,000* (1 –0.35)], while her after-tax benefit for the dividend is $170,000 [$200,000 * (1 – 0.15)].

Part B

Green Corporation’s after-tax cost for the bonus is $198,000 [$300,000 bonus – ($300,000 * 0.34) taxes saved], while its after-tax cost for the dividend is $200,000 (the dividend is not deductible).

Part C

Sophie should choose the $300,000 bonus instead of the $200,000 dividend because the after-tax benefit of bonus is greater.

Green should choose the $200,000 bonus instead of the $300,000 bonus because the after-tax benefit of dividend is greater.