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 35%. 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.

Question

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If the business makes an S corporation election, the losses in year 0 will pass through to Loretta’s personal income tax return and offset other sources of income. The tax savings from the $100,000 loss in year 0 would be $35,000 (35% * $100,000). In year 1, the corporation is projected to have a profit of $150,000, resulting in a tax cost of $52,500 (35% * $150,000). In year 2, the corporation is projected to have a profit of $250,000, resulting in a tax cost of $87,500 (35% * $250,000). Using a 10% discount rate, the present value of the tax savings is $30,219, and the present value of the tax costs is $124,967. Therefore, the net tax cost over the three years is $93,748. Option B is correct.

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