Loretta plans to start a small business,operated through a corporation.In year 0,she expects the corporation to generate a loss of $100,000.Subsequently,she expects the corporation to be profitable,and projects profit of $150,000 in year 1,and $250,000 in year 2.Loretta's personal marginal tax rate on ordinary income is 39.6%.Using Appendix A and a 10% discount rate,calculate the present value of expected tax savings and costs on the business earnings for the first 3 years of operations if the business makes an S corporation election.
A)$118,800 total tax cost
B)$96,169 total tax cost
C)$99,772 total tax cost
D)$0

Question

Quizplus · Accepted Answer

If the business elects to be treated as an S corporation, the losses and profits of the corporation will flow through to Loretta's personal income tax return. In year 0, the $100,000 loss can be used to offset other income, resulting in a tax savings of $39,600. In year 1, the profit of $150,000 would result in a tax cost of $59,400. In year 2, the profit of $250,000 would result in a tax cost of $99,000. 
The present value of these tax savings and costs can be calculated using the formula: 
PV = (Cash flow / (1+r)^t) 
where PV is the present value, r is the discount rate, and t is the time period. 
Using a 10% discount rate, the present value of the tax savings in year 0 is $36,000. The present value of the tax cost in year 1 is $50,233, and in year 2 is $56,936. 
Adding these together, the total present value of tax costs and savings is $96,169. Therefore, the best choice is B, with a total tax cost of $96,169.

Loretta Plans to Start a Small Business,operated Through a Corporation