Reference no: EM132615823

First, as a sole proprietor, A will pay $350,000 in tax and have $650,000 left. Second, as a C corporation (or S corporation) paying out all net earnings as salary, the corporation will pay no income tax and thus theoretically could pay out the entire $1 million (disregarding employment taxes and local taxes), in which case A again will net $650,000. This, however, may not be possible or desirable, and part of such salary could be recharacterized as a dividend (but since 2003, taxation as a dividend is only 15 percent). Third, if $500,000 is paid to A as salary, then A will net $325,000 on $500,000 income and the corporation will net $325,000 on $500,000 income (note that because this is a personal service corporation, the lower brackets are not available under § 11(b)(2)). A can appropriate the retained earnings of $325,000 to his personal use by a dividend from which A will net $275,000, for a total net to A of $600,000, or by a sale of the stock, in which we assume A has nominal basis, for $325,000 resulting in a capital gains tax of $50,000 and a total net to A of $575,000. Thus, while A may be able to approximate his sole proprietorship result by using a C corporation paying out virtually all earnings in salary, an accumulation in X coupled with payment of the second-tier tax on that accumulation (even at the lower 15 percent) will result in the short term in a lower net return to A than if A had used a sole proprietorship.

Problem 1: Discuss the lack of capital gain benefit for a C corporation taxpayer, and the limitation of use of capital losses.