Paul and Melba are going to form a business entity that sells antique jewelry. L
ID: 2427231 • Letter: P
Question
Paul and Melba are going to form a business entity that sells antique jewelry. Limited liability is a significant factor for the business. They have narrowed the choice of business entity to a C corporation or an S corporation. They expect the annual earnings of the business before taxes to be $100,000. Assume the marginal tax rate of Paul is 33% and of Melba is 33%. Advise Paul and Melba on the business entity form they should select if: • The after-tax earnings of the business are invested in the growth of the business. • The after-tax earnings of the business are distributed annually to the owners.
Explanation / Answer
Advise to Paul and Melba on the business entity form they should select if:
• The after-tax earnings of the business are invested in the growth of the business: They must choice C corporation because C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends. Thus, choicing it, they can escape the double taxation.
• The after-tax earnings of the business are distributed annually to the owners: Instead of C corporation, they should choice S corporation because S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners. Thus, they have to comply with only one taxation i.e. at personal level which is as low as 33% for both.