Harvey Redmond is planning a new business that he expects will grow into a large company within a few years. Harvey’s lawyer has advised him that large companies are usually C-type corporations because of stock market considerations, so he’s considering that form now to avoid reorganizing later on. However, he’s also concerned about the after tax income he’ll be able to take out of the business during the first few years. Harvey thinks his business will have pretax earnings (after paying his salary) of about $150,000 per year for the first three years. Does it make sense for him to operate as a proprietorship for three years and then reorganize into a C-type at an estimated cost of $80,000 or to choose the C-type now at essentially no additional cost? Assume a simplified tax system in which the corporate rate is 34% and Harvey’s personal tax rate is 28% on all income including dividends. Ignore the fact that the cash flows occur at different times and the possibility of using an S-type corporation or an LLC.

Question
Asked Mar 16, 2019

Harvey Redmond is planning a new business that he expects will grow into a large company within a few years. Harvey’s lawyer has advised him that large companies are usually C-type corporations because of stock market considerations, so he’s considering that form now to avoid reorganizing later on. However, he’s also concerned about the after tax income he’ll be able to take out of the business during the first few years. Harvey thinks his business will have pretax earnings (after paying his salary) of about $150,000 per year for the first three years. Does it make sense for him to operate as a proprietorship for three years and then reorganize into a C-type at an estimated cost of $80,000 or to choose the C-type now at essentially no additional cost? Assume a simplified tax system in which the corporate rate is 34% and Harvey’s personal tax rate is 28% on all income including dividends. Ignore the fact that the cash flows occur at different times and the possibility of using an S-type corporation or an LLC.

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Expert Answer

Step 1

Before answering this question, first let's understand how the profits will flow to Harvey in case of a C-type corporation and a proprietorship.

In case of C-type corporation:

  • The pre tax income of $ 150,000 will be the pre tax earning of the corporation
  • Corporation will pay income tax at the rate of corporate rate of 34%. Tax paid by the corporation = 34% x $ 150,000 = $ 51,000
  • Post tax income of the corporation will then flow to the owner Harvey Redmod as dividend = $ 150,000 - 51,000 = $ 99,000
  • Harvey will have to pay personal income tax on this dividend income =28% x 99,000 = $ 27,720
  • His cash receipt will thus be post tax dividend income = $ 99,000 - 27,720 = $ 71,280
Step 2

In case of proprietorship

  • The pre tax income will be income of the proprietor Harvey = $ 150,000
  • He will have to pay personal income tax rate on this amount = 28% x 150,000 = $ 42,000
  • His money receipt will be post tax income = 150,000 - 42,000 = $ 108,000
Step 3

Incremntal annual money received by Harvey in case of he operates the business under proprietorship = $ 108,000 - 71,280 = $ ...

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