Question

Assuming current tax rates ( Corp.tax 35%, Individual 39.6, Dividends and Capital gain 20%), identify the following as either true or false.Explain each answer.

a. The annualized after-tax rate of return to investing in the corporate form increases with the length of the investors holding period

b. The annualized after-tax rate of return to investing in the partnership form increases with the length of the partners holding period

c. If a corporation paid out its entire after-tax profits as dividends each year, shareholders would realize a lower after tax rate of return than if the corporation retained the after tax profits

d. Because the corporate rate is lower than the individual rate, the corporate form is preferred to the partnership form

e. Because corporate income is subject to two levels of tax, the partnership form is always preferred to the corporate form

Answer 1

Given, Corp. Tax Rate (Tc) = 35%, Individual Tax Rate (Tp) = 39.6%,

Dividends & Capital Gains Tax (Tcg) = 20%

A partnership is not a taxable entity. While it computes an informational tax return as if it were taxable, its taxable items are passed through to and reported by its partners. Whereas  a Corporation is a taxable entity, giving rise to the corporate double tax of approximately 35% + 20% on the remaining 65%, or a total potential tax burden of 48%.

In the case of a single period investment horizon, an investment in partnership form will dominate the same investment in corporate form if (1 – Tp) > (1 – Tc)(1 – Tcg).

Where the corporate tax rate is less than the individual tax rate and shareholder returns to corporate investment are taxed at any positive amount such that (1 – Tp) > (1 – Tc)(1 – Tcg), then the partnership investment dominates for a one-period investment but the corporate investment dominates if the investment horizon is sufficiently long.  The longer the investment horizon, the higher the after-tax corporate return becomes although the partnership return does not change

a. True

b. False

c. True

d. True (But the decision to incorporate an entity depends upon several other factors, such as the investment horizon, control etc.)

e. False