Question

Sandra 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 7 percent annual before-tax return on a $600,000 investment. Sandra’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Sandra organizes BAL as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional 0.9 percent for the additional Medicare tax. BAL’s income is not qualified business income (QBI) so Sandra is not allowed to claim the QBI deduction. Assume that BAL will distribute all of its after-tax earnings every year as a dividend if it is formed as a C corporation. (Round your intermediate computations to the nearest whole dollar amount.)

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

Answer 1

Solution:

a.) If Bal is organized as LLC
Annual return before taxes = $600,000 x 7% = $42,000
Marginal Income tax rate =37% Hence tax = $42,000 x 37% = $15,540
Self employment tax rate = 2.9% Hence self employment tax = $42,000 x 2.9% = $1,218
Medicare tax = 0.9% = $42,000 x 0.9% = $378
Total Taxes = $15,540+$1,218+$378 = $17,136
Hence after tax cash , Sandra will receive if business is LLC = $42,000 - $17,136 = $24,864

If BAL is organized as C Corp
C corps are taxed at 21% . Hence tax on income will be $42,000 x 21% = $8,820
In addition tax has to be paid at the individual level on the dividends received
Dividends received will be = $42,000 - $8,820 = $33,180
On the dividend,s tax at the the rate 23.8% has to be paid =$33,180 x 23.8% = $7,896.84
Total taxes paid = $8,820 + $7,896.84 = $16,716.84
Hence after tax cash , Sandra will receive if business if is a C corp = $42,000 - $16,716.84 = $25,283.16

b.

If BAL is LLC overall tax rate = Total taxes / Business Income
= $17,136/$42,000 x 100
= 40.8%
If BAL is a C Corp overall tax rate = Total taxes / Business Income
= $16,716.84/$42,000 x 100
= 39.80%