ACCT 412 Week 1 Group Discussion Board Forum 1 Example

Group Discussion Board Forum 1: Choice of Entity

ACCT 412 Corporate/Partnership/Estate Taxation, Group Discussion Board Forum 1

Thread by [Student Name]

The business, its owner and the classmates are composites; the textbook, Scripture and the research cited are real.

Diane owns a precision machine shop that earns $500,000 of taxable business income a year. She is the only owner, works full time in the business and pays herself a reasonable salary, which is already deducted in that figure. She is considering whether to operate as a C corporation or an S corporation, and she plans to take all of the profit out of the business each year to fund her retirement savings and a vacation property. For simplicity, I assume she is in the top federal bracket, that her shop's wages are high enough for the full 20% qualified business income deduction and that state taxes are the same either way. I also ignore the 3.8% net investment income tax on the S corporation route, since income from a business in which the owner materially participates is generally not subject to it.

Spilker et al. (2018) explain that a C corporation's income is taxed once at the corporate level and again when distributed as dividends, while S corporation income passes through to the owners and is taxed once. On Diane's plan to distribute everything, the C corporation costs her about $51,000 more each year. The S corporation figure is an upper bound, since some of her income would fall in brackets below 37%. Spilker et al. (2018) also note that the corporate rate applies to every dollar, with no graduated brackets since 2018, which makes the C corporation figure easy to predict but hard to reduce.

The decision matters at the level of the economy as well as for Diane. Goolsbee (2004) used state data on organizational form and found that higher corporate tax rates relative to personal rates reduced the share of activity conducted in corporate form, which shows that businesses do choose entities partly for tax reasons. Cooper et al. (2016) reported that pass-throughs had come to earn the majority of U.S. business income and that the average federal income tax rate on pass-through income was about 19%, well below the rate on corporate income once both layers are counted. Their findings help explain why the 21% corporate rate did not cause a rush back to C corporations: for owners who take profits out, two layers still cost more than one. Chapter 17's treatment of accounting for income taxes adds a reporting angle: a C corporation records its own tax expense and deferred taxes, while a pass-through records almost none, which changes how its statements look to a lender.

The answer changes if Diane's plans change. If she reinvested every dollar to grow the shop, the C corporation's single 21% layer would be the cheapest option this year. She would pay the dividend tax only when she eventually took the money out, and possibly never on the portion she held until death. My position is that distribution policy, not the 21% headline rate, should drive entity choice, and that an adviser should ask about the owner's five-year plans before recommending an entity.

Proverbs 21:5 contrasts the careful planner, whose plans lead to plenty, with the hasty person headed for poverty (English Standard Version Bible, 2001/2016). Choosing an entity in haste, because a rate sounds low, is the kind of hurried decision the proverb warns against. Careful comparison of the alternatives serves both the owner and the honest administration of the tax law.

Reply to Logan

Logan, you recommended that Diane form an LLC because it protects her personal assets from the shop's liabilities, and I agree that liability protection should be part of the decision. The point I would add is that an LLC is a legal form under state law, not a tax classification. Spilker et al. (2018) explain that the IRS ignores a one-owner LLC by default, treating its income as the owner's, while letting it elect corporate status and then, where eligible, S status. That means Diane does not have to choose between liability protection and the tax results in my table: she can form an LLC for protection and still elect S corporation status. The election matters for one more reason. As a disregarded LLC, all of her $500,000 would be subject to self-employment tax, while as an S corporation only her salary would bear payroll taxes, and the remaining profit would not. That difference can be several thousand dollars a year, although the IRS requires that the salary be reasonable for the work performed. At her income, the Medicare portion alone applies without any cap. Cooper et al. (2016) found that S corporations are the most common business form for many high-income owners, which is consistent with this combination of protection and tax savings. I would suggest she form an LLC and elect S status, with a documented reasonable salary. She should also review her state's treatment of S corporations, since a few states tax them at the entity level.

Reply to Hailey

Hailey, you focused on how an S corporation lets Diane avoid payroll taxes on the portion of profit she takes as distributions, and that is a real advantage. The limit is the reasonable compensation requirement. If Diane paid herself only $40,000 while running a shop that earns $500,000, the IRS could reclassify part of her distributions as wages and assess the employment taxes, interest and penalties. Spilker et al. (2018) note that courts look at what the business would pay an unrelated person to do the same work, considering duties, hours and comparable salaries. For a skilled machinist who also manages the business, a salary well above $40,000 is likely necessary. There is also an interaction with the qualified business income deduction. Wages paid to the owner reduce qualified business income, but at higher incomes the deduction is limited by the W-2 wages the business pays, so a very low salary could reduce the deduction itself. That means the most aggressive payroll tax strategy may cost Diane part of the 20% deduction. The two rules pull in opposite directions, so the right salary is a balance, not a minimum. Goolsbee (2004) found that businesses respond to the relative tax burdens of different forms, and the reasonable salary rule is how the law keeps that response within bounds. A salary set from market data, documented each year, protects the payroll tax savings you identified while avoiding the reclassification risk. Diane's accountant could document the salary with industry wage surveys and update it each year as the shop grows.

References

Cooper, M., McClelland, J., Pearce, J., Prisinzano, R., Sullivan, J., Yagan, D., Zidar, O., & Zwick, E. (2016). Business in the United States: Who owns it, and how much tax do they pay? Tax Policy and the Economy, 30(1), 91-128. https://doi.org/10.1086/685594

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Goolsbee, A. (2004). The impact of the corporate income tax: Evidence from state organizational form data. Journal of Public Economics, 88(11), 2283-2299. https://doi.org/10.1016/j.jpubeco.2003.05.002

Spilker, B. C., Ayers, B. C., Barrick, J. A., Lewis, T. K., Robinson, J. R., Weaver, C. D., Worsham, R. G., & Outslay, E. (2018). Taxation of individuals and business entities (Custom ed.). McGraw-Hill Education.