Question

John owns a craft store. Currently the craft store is operated as a sole proprietorship and generates an annual operating profit of $120,000. In addition, the store earns annual dividends of $5,000 from investing excess working capital in the stock of publicly traded corporations. The stock investments typically are held for a minimum four to five months before funds are required for the business. As result of income from other business ventures and investments, John is in the 37 percent marginal tax rate bracket before considering store operations. In the past, John has withdrawn $60,000 annually from the store, as salary. John has asked you about the tax consequences of conducting the business as a regular C corporation. Based on the given information, what would be the annual income tax savings (or cost) of operating the bakery as a C corporation? For purposes of this analysis, use the 2018 tax rates and ignore any employment or state tax considerations.

Answer 1

Conducting the business as a regular C Corporation leads to double taxation. Tax at 21% at C Corporation level and tax on distribution of dividend to sole propreitor leading to tax at 20%. This double tax is more than the 37% marginal tax rate of John.

However C Corporation can fully deduct state and local taxes whereas an individual can deduct only upto a maximum of $10000. The tax effect of this may be marginal.  

Thus proper number crunching is required to decide whether the business should be conducted as a C corporation or sole propreitor. Normally double taxation is the primary reason for choosing sole propreitorship over C Corporation.