Introduction: Richard plans to invest $100,000 for a 50 percent interest in a sm
ID: 2724830 • Letter: I
Question
Introduction:Richard plans to invest $100,000 for a 50 percent interest in a small business. His friend Jack will also invest $100,000 for the remaining 50 percent interest. On their investment, they expect to generate 10 percent before-tax return the first year. Richard’s marginal tax rate is 33 percent, and Jack’s marginal tax rate is 35 percent. They need to decide whether to establish the business as a partnership or as a C corporation.
Task:
a If they establish a partnership, compute the after-tax cash flow for each partner if each of them withdraws $4,000 from the profits of the business the first year. What is the amount of cash that remains in the partnership, exclusive of employment taxes.
b If they establish a C corporation, compute the after-tax cash flow for each shareholder if each of them receives a dividend of $4,000 from the profits of the business the first year. What is the amount of cash that remains in the C corporation?
c What nontax factors should Richard and Jack consider when making this decision?
After a detailed analysis, what would you recommend? Do you feel Richard and Jack should establish a partnership or a C corporation?
Explanation / Answer
a.The partnership has income of $20,000 ($200,000 x 10%) but will pay no taxes;
thus, it will have cash remaining in the partnership of $12,000 ($20,000 - $8,000
distributed to Richard and Jack). Richard and Jack will each pay taxes on their one-
half share of the partnership’s $20,000 income. Richard will pay income tax of
$3,300 ($10,000 x 33%); Jack will pay income tax of $3,500 ($10,000 x 35%).
Richard will have a net cash flow of $700 ($4,000 – $3,300) and Jack will have a
net cash flow of $500 ($4,000 - $3,500). Total taxes paid are $6,800 ($3,300 +
$3,500).
b. The corporation will have to pay $3,000 ($20,000 x 15%) tax on its income.
After the $8,000 dividend distribution to Richard and Jack, its remaining cash is
$9,000 ($20,000 – $3,000 - $8,000). Richard and Jack will each have to pay $600
($4,000 dividend x 15% dividend rate) in income taxes. Richard and Jack’s net
cash flow is $3,400 ($4,000 - $600). Total tax is $4,200 ($3,000 + $600 + $600).
c. Some of the nontax factors that Richard and Jack should consider include their
exposure to liability as partners in the partnership, their ability to raise additional
capital, the ease of selling their ownership interests, and their participation in fringe
benefits. Under the conditions outlined above, they must also have sufficient
outside income to absorb their negative cash flow from the partnership.
d. As presented, it appears that the corporation offers the best alternative form of
business. They are able to benefit from corporation’s lower tax rates and this form
provides the best overall cash flow considering both the business and the owners at
this time. Richard and Jack are paying very high taxes on income that flows
through to them from the partnership. With the limited distributions made, they
have little positive cash flow. If they intend to leave most of the income in the
business, they can avoid the taxes at their level through the corporate form. If at a
later date, they need income, they can make additional dividend distributions.
e. Considering employment taxes: a. The partnership will still generate $20,000 of
income but pay no taxes. When it distributes the $8,000 to the partners, its cash
remaining remains $12,000. Richard and Jack will each have to pay self-
employment taxes on the $10,000 (50% x $20,000) of income passed through to
them. $10,000 x 92.35% x 15.3% = $1,413 each or $2,826 for both. They will each
be able to deduct one-half of their self-employment taxes from the $10,000 income
passed through from the partnership. Thus, they will pay income taxes on $9,294 of
income [$10,000 – (50% x $1,413)]. Richard will have to pay income taxes of
36 Solutions Manual for Taxation for Decision Makers
$3,067 ($9,294 x 33%) on this income. Jack will have to pay income taxes of
$3,253 ($9,294 x 35%) on this income.
As each of them receives only a $4,000 distribution from the partnership, they will
each have a negative cash flow. Richard’s negative cash flow is -$480 ($4,000 -
$1,413 SE tax - $3,067 income tax). Jack’s negative cash flow is -$666 ($4,000 -
$1,413 SE tax - $3,253 income tax).
Total taxes are $9,146 ($1,413 + $1,413 + $3,067 + $3,253).
The answers to b. will not change. Dividends are not self-employment income and
are only subject to income taxes. When employment taxes are considered, the
corporate form is even more attractive.
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