Question

1) Andy, Jim and Dwight are starting a professional paper shredding company, and they are still exploring the pros and cons of the following types of legal entities:

C-corporation

Limited partnership

S-corporation

Andy and Jim will each contribute $200,000 in cash in exchange for their ownership interest. Dwight will contribute a warehouse that he owns that will be used to house the shredder machines. The warehouse has an FMV of $290,000 and is encumbered by a $90,000 mortgage. Dwight purchased the warehouse 3 years ago for $180,000. It was agreed that the profit and loss from the company's operations will be divided equally (i.e. 1/3 each) amongst the three owners.

Andy will manage the company's operations in exchange for $75,000 in compensation per year. Jim and Dwight will have minimal involvement in the company's operations, as they also own and manage full-time a company they formed as an LLC that sells pickled beets.

In addition to the $90,000 mortgage on the warehouse that is considered qualified nonrecourse financing, the company will also have a $180,000 recourse loan with a local bank and $75,000 in nonrecourse accounts payable. Jim and Dwight will not be included as guarantors for the recourse loan.

Assume instead that Andy, Jim and Dwight decided to form an S-corporation. In its first year of operations, the S-corporation generated ordinary income of $270,000 and made a cash distribution of $108,000 to the shareholders.

The ordinary income allocated to the shareholders is considered qualified business income; therefore, the shareholders are allowed to deduct 20% of their allocable share of ordinary income on their Form 1040.

(Important Note: The ordinary income allocated to Jim and Dwight is considered passive activity income that is subject to the net investment income tax. The qualified business income deduction cannot reduce their passive activity income for purposes of computing the net investment income tax only).

What would the overall effective tax rate be (corporate + individual tax impact) on the $270,000 taxable income earned in the first year? Do not include the impact on Andy's tax liability for his compensation received from the corporation.

Applicable tax rates:

Corporate - 21%

Individual - ordinary income - 37%

Individual - qualified dividend income - 20%

Individual - net investment income - 3.8%

Multiple Choice

32.64%

30.52%

32.13%

29.60%

2) Although the limited partnership is also a flow-through entity and allows for the 20% qualified business deduction similar to the S-corporation, Andy's effective tax rate would be higher if the owners formed a limited partnership when compared to his effective tax rate with an S-corporation due to the additional imposition of self-employment taxes.

TRUE or FALSE??

Answer 1

Computation of overall effective tax rate for C corporation

	c corporation	Description
(1)Taxable income	$ 270000
(2)Entity level tax	$ 56700	(1) x 21%
(3)After tax entity earning	$ 213300	(1) - (2)
(4)Cash distribution	$ 108000
(5)Share holders tax
Ordinary tax	-
Dividend tax	$ 21600	(4) x 20%
Net investment income tax	$ 4104	(4) x 3.8%
Total share holders tax	$ 25704
(6)Total tax (corporate + individual)	$ 82404	(2) + (5)
Overall effective tax rate	30.52%	(6) / (1)

In above case we added entity level tax,dividend tax, net investment income tax for calculate overall effective tax rate.