Question

Calculate the tax disadvantage to organizing a U.S. business today if the Jobs and Growth Tax Reconciliation Act of 2003 passed with this provision. Consider the following firm: All earnings will be paid out as dividends, and operating income before taxes will be $1,250,000. The effective corporate tax rate is 35%, and the tax rate on corporate dividends is 10%. The average personal tax rate for partners in the business is 35%. What is the tax disadvantage?

7.0%

8.0%

6.75%

6.5%

Answer 1

Let us first list down the information provided in question:

Operating Income before taxes = $ 1,250,000

Corporate Tax rate = 35%

Tax rate on corporate dividends = 10%

Average personal tax rate for partners = 35%

If all earnings are paid out by Corporation, than corporation has to pay corporate taxes @ 35% and dividends are taxed in the hands of shareholders on corporate dividend rate @ 10%

Calculation of distributed earnings by Corporation

Operating Income before taxes = $ 1,250,000

Less: Corporate taxes @ 35% = $ 437,500

Operating Income after taxes = $ 812,500

Calculation of Net Income of Shareholders

Dividends received from Corporation = $ 812,500

Less: Tax on corporate dividends @ 10% = $ 81,250

Net Income of shareholders = $ 731,250

If all earnings are retained by corporation, than corporation need to taxes @ 35%

Calculation of distributed earnings by corporation

Operating Income before taxes = $ 1,250,000

Less: Corporate taxes @ 35% = $ 437,500

Operating Income after taxes = $ 812,500

Tax Disadvantage = $ 812,500 - $ 731,250

= $ 81,250

= $ 81,250 / 1,250,000

= 6.50%

Trust the same will serve your purpose.

Should you need any clarifications, please feel free to comment.