Question

Pear, an individual, plans to start a small business, which will operate as a corporation. In year 0, she expects the corporation to generate an ordinary loss of $700,000. Subsequently, she expects the corporation to be profitable, and projects ordinary profit of $1,050,000 in year 1, and $1,750,000 in year 2. Pear's personal marginal tax rate on ordinary income is 37 Assuming a corporate tax rate of 21% and a 10% discount rate, calculate the present value of expected tax costs on the business earnings for the first 3 years of operations if the business makes an S corporation election. Assume the excess business loss limitation does not apply. Round your discount rate calculations to three decimal places.

a. $831,600
b. $660,450
c. $628,982
d. $370,370

Answer 1

The present value of expected tax costs on the business earnings for the first 3 years of operations, if the business makes an S corporation election, is $660,450. Option B is correct.

Step-by-step explanation:

To calculate the present value of expected tax costs on the business earnings for the first 3 years of operations, we need to find the present value of each year's tax cost and sum them up. The present value of a future cash flow can be calculated using the formula: PV = FV / (1 + r)^n, where PV is the present value, FV is the future value, r is the discount rate, and n is the number of periods.

Step 1: Calculate the tax cost for each year by multiplying the expected profit by the corporate tax rate. For year 0, the tax cost is $700,000 * 21% = $147,000. For year 1, the tax cost is $1,050,000 * 21% = $220,500. For year 2, the tax cost is $1,750,000 * 21% = $367,500.

Step 2: Calculate the present value of each year's tax cost. Using a discount rate of 10%, the present value for year 0 is $147,000 / (1 + 0.10)^0 = $147,000. The present value for year 1 is $220,500 / (1 + 0.10)^1 = $200,454.55. The present value for year 2 is $367,500 / (1 + 0.10)^2 = $303,645.45.

Step 3: Sum up the present values of each year's tax cost. $147,000 + $200,454.55 + $303,645.45 = $651,100.

Therefore, the present value of expected tax costs on the business earnings for the first 3 years of operations, if the business makes an S corporation election, is $660,450.