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 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) $99,169 total tax cost
C) $99,772
D) $0

Question

Quizplus · Accepted Answer

To calculate the present value of expected tax savings and costs, we need to calculate the tax on the earnings assuming the business is taxed as a C corporation and then subtract the tax on the earnings assuming the business makes an S corporation election. The difference is the tax savings or costs.

Assuming the business is taxed as a C corporation:
- Year 0: tax savings of $0 (loss carryforward)
- Year 1: tax of $58,200 ($150,000 * 39.6%)
- Year 2: tax of $99,000 ($250,000 * 39.6%)

Total tax cost as a C corporation = $157,200

Assuming the business makes an S corporation election:
- Year 0: tax savings of $39,600 (loss pass-through to Loretta)
- Year 1: tax of $0 (pass-through of loss carryforward from year 0)
- Year 2: tax of $54,600 ($250,000 - $100,000 * 35% = $122,500 * 39.6%)

Total tax cost as an S corporation = $94,200

To calculate the present value, we use the formula:

PV = CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+r)^3

PV_C = -$157,200/(1+0.1)^1 +(0)/(1+0.1)^2 +(-$58,200)/(1+0.1)^3 +(-$99,000)/(1+0.1)^4 = -$270,444.77
PV_S = -$39,600/(1+0.1)^1 +(0)/(1+0.1)^2 +(-$0)/(1+0.1)^3 +(-$54,600)/(1+0.1)^4 = -$70,275.22

PV of tax savings = PV_C - PV_S = -$270,444.77 - (-$70,275.22) = -$200,169.55

Therefore, the present value of expected tax savings and costs is $200,169.55, which is equivalent to a total tax cost of $99,169. Option B is the correct answer.

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