Question

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 24 percent, and Jack’s marginal tax rate is 32 percent.Their tax rate for capital gains and dividend income is 15 percent They need to decide whether to establish the business as a partnership or as a C corporation.

Answer 1

Answer

a. If they establish a partnership, compute the after-tax cash flow for each partner if each of them withdraws $4,000 of the profits from the business the first year. What is the amount of cash that remains in the partnership?

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 $2,400 ($10,000 x 24%); Jack will pay income tax of $3,200 ($10,000 x 32%). Richard will have an after-tax cash inflow of $1,600 ($4,000 – $2,600) and Jack will have an after-tax cash inflow of $800 ($4,000 - $3,200). Total taxes paid are $5,600 ($2,400 + $3,200).

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?

b.

The corporation will have to pay $4,200 ($20,000 x 21%) tax on its income. After the $8,000 dividend distribution to Richard and Jack, its remaining cash is $7,800 ($20,000 – $4,200 - $8,000). Richard and Jack will each have to pay $600 ($4,000 dividend x 15% dividend rate) in income taxes. Richard and Jack each have an after-tax cash inflow of $3,400 ($4,000 - $600). Total tax is $5,400 ($4,200 + $600 + $600).

c. What non-tax factors should Richard and Jack consider in making this decision?

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.

d. What you do recommend?

d.

As presented, it appears that the corporation offers the best alternative form of business. They are able to benefit from the 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.   

Note that when employment taxes are considered (discussed in Chapter 4), the corporate form is even more attractive.