Question

Required information

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 Andy, Jim and Dwight decided to form a C-corporation. In its first year of operations, the C-corporation generated taxable income of $270,000 and made a cash distribution of $108,000 to the shareholders. The distribution is characterized as a qualified dividend and is subject to the net investment income tax.

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

A.21.00%

B.30.52%

C.29.00%

D.34.32%

Answer 1

Solution:
Computation of overall effective tax rate for C Corporation:
	C Corp.	Description
(1) Taxable income	$ 270,000.00
(2) Entity level tax	$   56,700.00	(1) x 21%
(3) After tax entity Earnings	$ 213,300.00	(1) - (2)
(4) Cash Distribution	$ 108,000.00
(5) Shareholders tax
Ordinary tax	$                 -
Dividend tax	$   21,600.00	(4) x 20%
Net investment income tax	$     4,104.00	(4) x 3.8%
Total shareholder tax	$   25,704.00
(6) Total tax (Corporate + Individual)	$   82,404.00	(2) + (5)
Overall effective tax rate	30.52%	(6)/(1)