Question

Andrea would like to organize SHO as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 15 percent annual before-tax return on a $740,000 investment. Andrea’s marginal income tax rate is 35 percent and her tax rate on dividends and capital gains is 15 percent. Andrea will also pay a 3.8 percent net investment income tax on dividends and capital gains she recognizes. If Andrea organizes SHO as an LLC, Andrea 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. Further, she is eligible to claim the full deduction for qualified business income. Assume that SHO will pay out 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 Andrea receive from her investment in the first year if SHO is organized as either an LLC or a C corporation?

b. What is the overall tax rate on SHO’s income in the first year if SHO is organized as an LLC or as a C corporation? (Round your final answers to 2 decimal places.)

Answer 1

Working Note 1

Below is the explanation of SHO as an LLC and a C corporation.

a)

Sl No.	Particulars	LLC	Calculation	C corporation	Calculation
1	Investment	$740,000		$740,000
2	Before tax return	$111,000	15% of (1) = 15% * 740,000	$111,000	15% of (1) = 15% * 740,000
3	Entity level tax rate	0%		*21%
4	Entity-level tax	0		$23,310	(2) * (3)
5	Earnings after entity level tax	$111,000	(2)-(4)	$87,690	(2)-(4)
6	QBI deduction	$22,200	(5) * 20%	NA
7	Deductionfor 50 percent of SE tax	$1,486	(2) * 0.9235*0.029*50%	NA
8	Net income taxable to owner	$134,686	(5) + (6) + (7)	$87,690	(5) - Distributed as divided
9	Income tax paid by owner	$47,140	(8) * 35%	$13,154	(8) * 15%
10	Self-employment tax	$2,972	(2) * 0.9235*0.029	NA
11	Additional Medicare tax/Net investment income tax	$923	(2) * 0.9235*0.009	$3,332	(8) * 0.038
12	Owner-level tax	$51,035	(9) + (10) + (11)	$16,468	(9) + (11)
13	After-tax cash flow	$59,965	(2)- (12)	$71,222	(8)- (12)

b)

Owner-level tax	$51,035	(9) + (10) + (11)	$16,468	(9) + (11)
After-taxcash flow	$59,965	(2)- (12)	$71,222	(8)- (12)
Overall tax rate	45.98%	(12) / (2)	35.84%	[(4) + (12)]/2

Conclusion : From the above table, the after tax earnings for SHO as an LLP and as a C corporation is $ 59,965 and $ 71,222 respectively.

Note :

* The Tax Cuts and Jobs Act (TCJA) introduced a flat 21% federal income tax rate for C corporations for tax years beginning in 2018 and beyond. Under prior law, profitable C corporations paid up to 35%.