You are currently working at a mid-sized certified public accounting firm. Your

Question

You are currently working at a mid-sized certified public accounting firm. Your client is Bob Jones. Bob, age 60 and single, has recently retired from IBM. He has $690,000 available in his 401(k) fund and he is thinking of using that money to open a used car business that will be located at 210 Ocean View Drive in Pensacola, Florida. Bob has estimated that the business might make $300,000 in taxable income. Bob’s personal wealth including investments in land, stocks, and bonds is about $14,000,000. He reported an interest income of $20,000 and dividend income of $6,000 last year. The $14,000,000 includes land worth $9,000,000 that Bob bought in 1966 for $450,000. Bob has hired your firm for professional advice regarding whether he should operate as a sole proprietor, a partnership, an S corporation, or a C corporation( in which I chooses a sole proprietor). He is also considering transferring a possible 40% interest in his new business to his daughter Mandy, age 23 and single.

REQUIRED:

1. Illustrate how creative problem solving and versatility of thought impact professional advice that you intended to result in the best economic solutions for the client. Consider providing real-world examples to support your claims.

Explanation / Answer

Creative problem solving is as ancient concept as humans. It helps in problem solving and decision making if the 7 steps of CPS are properly followed.

CPS Steps

No. The sole proprietorship is a wrong choice. I would advice Bob jones to operate as a S corporation because of the tax benefits.

Simple Example
Here is a simple example. Let’s say you have two self-employed people, Sam and Carrie, who are both freelance photographers. Their businesses make the same net profits of $60,000 last year ($5,000/month). The only difference is that Sam is a Sole Proprietorship and Carrie is an S-Corporation.

Because Sam is a sole proprietorship, there is no difference between him and the business. They are one and the same. Therefore he has to pay self-employment taxes (Social Security + Medicare) of 15.3% on the entire $60,000 annual net profit, or about $9,200. He also must pay federal and local income taxes on that income.

Carrie is a bit different. She incorporated her one-person business into an S-Corporation, which is a separate entity. She wears two hats: she is the sole shareholder of that corporation, and also the sole employee.

S-Corporation are a ‘pass-through’ entity, which means all the profits of the corporation pass through directly to the shareholders’ tax returns. S-Corps do not pay corporate income taxes. However, the classification of this profit also matters:

As an employee, she just assigns herself a “reasonable salary” as required by the IRS. She does some research, and finds that similar photographers in her area earn $25 an hour. $25 an hour x 40 hours a week = $1000/week, or $4,000/month. So her salary is $4,000/month.

As the corporation shareholder, she owns a business with $5,000 of overall profits each month, but also pays out $4,000 for that one extremely loyal employee. That means $1,000 per month is not paid out as salary, and will be distributed to the shareholders (her) as dividends, or unearned income.

At tax time, Carrie gets $48,000 a year in earned income as an employee, and $12,000 in S-Corp distributions as a shareholder. You only pay self-employment taxes on earned income. $48,000 x 15.3% = $7,400. She also must pay federal and local income taxes, the same amount as Sam.

So as an S-Corporation, Carrie paid $1,800 a year less than Sam in taxes.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.