Question

Amanda would like to organize BAL as either an LLC (taxed as a sole proprietorship) or a C corporation. In either form, the entity is expected to generate an 8 percent annual before-tax return on a $500,000 investment. Amanda’s marginal income tax rate is 37 percent and her tax rate on dividends and capital gains is 23.8 percent (including the 3.8 percent net investment income tax). If Amanda organizes BAL as an LLC, she will be required to pay an additional 2.9 percent for self-employment tax and an additional 0.9 percent for the additional Medicare tax. Also, she is eligible to claim a full deduction for qualified business income on BAL’s income. Assume that BAL will distribute half of its after-tax earnings every year as a dividend if it is formed as a C corporation.

Answer 1

The question examines the tax implications of organizing a business as an LLC (taxed as a sole proprietorship) versus a C corporation. We looked at how an LLC results in taxation at the personal income tax rate, including self-employment and Medicare taxes, while a C corporation involves a flat corporate tax rate with double taxation on dividends.

Step-by-step explanation:

The question is looking at different tax implications for Amanda if she decides to organize her business entity, BAL, as either an LLC (Limited Liability Company) taxed as a sole proprietorship or a C corporation. Here, we consider the potential tax rates, the impact of her marginal income tax rate, and other relevant taxes. For an LLC, Amanda would be subject to her personal income tax rate of 37 percent on the profits, with the added burden of self-employment taxes, which include 2.9 percent for self-employment tax and an additional 0.9 percent for Medicare tax.

However, she could claim a full qualified business income deduction, which could mitigate the tax liability. In contrast, a C corporation would be taxed at the corporate rate, detailed by the tax policy source, followed by a second layer of tax on dividends at Amanda's capital gains/dividend tax rate. Moreover, the decision to distribute half of the after-tax earnings annually as dividends if BAL is formed as a C corporation, might increase the total tax paid when compared with an LLC.

According to the provided reference, C corporation tax rates are 34 percent for incomes falling between $335,000 to $10,000,000, increasing slightly to 35 percent for incomes above $18,333,333. For self-employed individuals, the main federal taxes paid are income tax, self-employment tax, and potentially others depending on the specifics of their situation, such as additional Medicare tax.

The Social Security tax, often a concern for self-employed individuals as they have to pay both the employee and employer portion resulting in a 12.4% rate on income below a specific threshold, is considered a regressive tax since it caps at $113,000, meaning higher earners do not pay this tax on income above that threshold, leading to a lower effective tax rate on their total income.