Question & Answer

Tremaine would like to organize UTA as either an S Corporation or a C corporation. In either form, the entity will generate a 9 percent annual before-tax return on a $1,000,000 investment. Tremaine’s marginal income tax rate is 37 percent, and his tax rate on dividends and capital gains is 23.8 percent (including the net investment income tax). If Tremaine organizes UTA as an S corporation, he will be allowed to claim the deduction for qualified business income. Also, because Tremaine will participate in UTA’s business activities, the income from UTA will not be subject to the net investment income tax. Assume that UTA will pay out 25 percent of its after-tax earnings every year as a dividend if it is formed as a C corporation.

a. How much cash after taxes would Tremaine receive from his investment in the first year if UTA is organized as either an S corporation or as a C corporation? 

b. What is the overall tax rate on UTA’s income in the first year if UTA is organized as an S corporation or as a C corporation?

c. What is the overall tax rate on UTA’s income in the first year if it is organized as an S corporation, but UTA’s income is not qualified business income?

d. What is the overall tax rate on UTA’s income if it is organized as an S corporation, UTA’s income is not qualified business income, and Tremaine is a passive investor in UTA?

Sandra would like to organize LAB (a legal corporation) as either an S corporation or a C corporation for tax purposes. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Sandra’s marginal income tax rate is 37 percent and her tax rate on qualified dividends and net capital gains is 20 percent. LAB’s income is not qualified business income (QBI) so Sandra is not allowed to claim the QBI deduction. Assume that LAB will distribute all of its earnings after entity-level taxes every year. Ignore the additional Medicare tax and the net investment income tax when computing your answers.

a. How much cash after taxes would Sandra receive from her investment in the first year if LAB is organized as either an S corporation or a C corporation? 

b. What is the overall tax rate on LAB’s income in first year if LAB is organized as an S corporation or as a C corporation?

c. At a high level, explain the differences between entity types in after-tax cash flow and overall tax rate on business income.

Amanda would like to organize BAL as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Amanda’s marginal income tax rate is 37 percent, and her tax rate on qualified dividends and net capital gains is 20%. Assume that BAL will distribute half of its after-tax earnings every year as a dividend if it is formed as a C corporation. Assume the income is not eligible for the QBI deduction. Further, when computing your answers, include the self-employment tax (use a 2.9% marginal rate for self-employment income because Amanda has salary in excess of the wage base limit) but not the additional Medicare tax or the net investment income tax. 

a. How much cash after taxes would Amanda receive from her investment in the first year if BAL is organized as an LLC? What if BAL is organized as a C corporation? 

b. What is the overall tax rate on BAL’s income in the first year if BAL is organized as an LLC or it is organized as a C corporation?

c. At a high level, explain the primary factors contributing to differences between entities in cash flow and overall tax rate on business income.

Jacob is a member of WCC (an LLC taxed as a partnership). Jacob was allocated $100,000 of business income from WCC for the year. Jacob’s marginal income tax rate is 37 percent. The business allocation is subject to 2.9 percent of self-employment tax (Jacob has salary in excess of the wage base limitation) and .9 percent additional Medicare tax.   

a. What is the amount of tax Jacob will owe on the income allocation if the income is not qualified business income? 

b. What is the amount of tax Jacob will owe on the income allocation if the income is qualified business income (QBI) and Jacob qualifies for the full QBI deduction?

Omar (single) is a 50 percent owner in Cougar LLC (taxed as a partnership). Omar works half time for Cougar and receives a guaranteed payment of $50,000. Cougar LLC reported $450,000 of business income for the year. Before considering his 50 percent business income allocation from Cougar and the self-employment tax deduction (if any), Omar’s adjusted gross income is $210,000 (includes $50,000 guaranteed payment from Cougar and $180,000 salary from a different employer). Omar reports itemized deductions of $40,000. Answer the following questions for Omar.

a. What is Omar’s self-employment tax liability?

b. What would be Omar’s self-employment tax liability if he didn’t receive any salary.

c. Assume the original facts and that the business income allocated to Omar is not from a specified service, what is Omar’s deduction for qualified business income? Assume that 81.82 percent of the self-employment tax is from self-employment income included in QBI [i.e., $225,000 business income allocation/$275,000 (business income allocation plus guaranteed payment)]. That is, the $50,000 guaranteed payment is not qualified business income. Ignore the wage-based limitation.

d. What is Omar’s net investment income tax liability (assume no investment expenses)?

e. What is Omar’s additional Medicare tax liability?

Sofia (single) is a 50 percent owner in Beehive LLC (taxed as a partnership). Sofia  does not do any work for Beehive. Beehive LLC reported $600,000 of taxable business income for the year. Before considering her 50 percent business income allocation from Beehive and the self-employment tax deduction (if any), Sofia’s adjusted gross income is $150,000 (all employee salary). Sofia has $35,000 in itemized deductions. Answer the following questions for Sofia.

a. What is Sofia’s self-employment tax liability?

b. Assuming the income allocated to Sofia is not from a specified service trade or business, what is Sofia’s deduction for qualified business income? Assume Sofia’s share of wages paid by Beehive LLC is $130,000 and her share in the unadjusted basis of qualified property used by Beehive was $300,000.

c. What is Sofia’s net investment income tax liability (assume no investment expenses)?

d. What is Sofia’s additional Medicare tax liability?

Mason (single) is a 50 percent shareholder in Angels Corp. (an S Corporation). Mason receives a $180,000 salary working full time for Angels Corp. Angels Corp. reported $400,000 of taxable business income for the year . Before considering his business income allocation from Angels and the self-employment tax deduction (if any), Mason’s adjusted gross income is $180,000 (all salary from Angels Corp.). Mason claims $50,000 in itemized deductions. Answer the following questions for Mason.

a. What is Mason’s self-employment tax liability?

b. Assuming the business income allocated to Mason is income from a specified service trade or business, what is Mason’s deduction for qualified business income? Ignore the wage-based limitation when computing the deduction. 

c. Assume the same facts as in question (b), except that Angels Corp. reported $150,000 of taxable business income for the year. What is Mason’s deduction for qualified business income? Ignore the wage-based limitation when computing the deduction.

d. Assuming the original facts, what is Mason’s net investment income tax liability (assume no investment expenses)?

e. Assuming the original facts, what is Mason’s additional Medicare tax liability?

Kiyara (single) is a 50 percent shareholder of Guardian Corporation (an S Corporation). Kiyara does not do any work for Guardian Corp. Guardian Corp. reported $300,000 of business income for the year. Before considering her business income allocation from Guardian Corp. and the self-employment tax deduction (if any), Kiyara’s adjusted gross income was $250,000 (all employee salary). Kiyara has $40,000 in itemized deductions. Answer the following questions for Kiyara.

a. What is Kiyara’s self-employment tax liability?

b. Assuming the income allocated to Kiyara is qualified business income, what is Kiyara’s deduction for qualified business income? Assume Kiyara’s share of wages paid by Guardian Corp. is $50,000 and her share in the unadjusted basis of qualified property used by Guardian was $200,000. 

c. What is Kiyara’s net investment income tax liability (assume no investment expenses)?

d. What is Kiyara’s additional Medicare tax liability (include all earned income in computing the tax)?

Visit your state’s official website and review the information there related to forming and operating business entities in your state. Write a short report explaining the steps for organizing a business in your state and summarizing any tax-related information you found.

What are the tax advantages and disadvantages of converting a C corporation into an LLC taxed as a partnership?

If business entities taxed as partnerships and S corporations are both flow-through entities for tax purposes, why might an owner prefer one form over the other for tax purposes? List separately the tax factors supporting the decision to operate a business entity as an entity taxed either as a partnership or as an S corporation.

Compare the entity-level tax consequences for C corporations, S corporations, and business entities taxed as partnerships for both nonliquidating and liquidating distributions of noncash property. Do the tax rules tend to favor one entity type more than the others? Explain. 

Explain how liabilities of an LLC (taxed as a partnership) or an S corporation affect the amount of tax losses from the entity that limited liability company members and S corporation shareholders may deduct. Do the tax rules favor LLCs or S corporations?

Compare and contrast the FICA tax burden of S corporation shareholder-employees and LLC members (assume the LLC is taxed as a partnership) receiving compensation for working for the entity (guaranteed payments) and business income allocations to S corporation shareholders and LLC members assuming the owners are actively involved in the entity’s business activities. How does your analysis change if the owners are not actively involved in the entity’s business activities? 

According to the tax rules, how are profits and losses allocated to owners of entities taxed as partnerships (partners or LLC members)? How are they allocated to S corporation shareholders? Which entity permits greater flexibility in allocating profits and losses?

Which tax entity types are generally allowed to use the cash method of accounting? 

Are C corporations or flow-through entities (S corporations and entities taxed as partnerships) more flexible in terms of selecting a tax year-end? Why are the tax rules in this area different for C corporations and flow-through business entities? 

Why are S corporations less favorable than C corporations and entities taxed as partnerships in terms of owner-related limitations?

ELS, an S corporation, reported a business loss of $1,000,000. Ethan, ELS’s sole shareholder, is involved in ELS’s daily business activities, and he reports $1,200,000 of taxable income from sources other than ELS. What must you know in order to determine how much, if any, of the $1,000,000 loss Ethan may deduct in the current year? Explain.

In its first year of existence, SMS, an S corporation, reported a business loss of $10,000. Sewon, SMS’s sole shareholder, reports $50,000 of taxable income from sources other than SMS. What must you know in order to determine whether she can deduct the $10,000 loss against her other income? Explain.

Would a corporation with a small amount of current-year taxable income (before the net operating loss deduction) and a large net operating loss carryover have a tax liability for the current year?  Explain.

Is a current-year net operating loss of a C corporation available to offset income from the corporation in other years? Explain.

When a C corporation reports a loss for the year, can shareholders use the loss to offset their personal income? Why or why not?

Why might it be a good tax planning strategy for an S corporation with one shareholder to pay a salary to the shareholder on the low end of what the services are potentially worth?

For tax purposes, how is the compensation paid to an S corporation shareholder similar to compensation paid to an owner of an entity taxed as a partnership?  How is it different?