Case 1:
Mrs. Lucci plans to start a new business venture. According to her five-year projection, the venture will operate at a loss for two years before becoming profitable. Here is the projection.
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Year 0
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Year 1
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Year 2
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Year 3
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Year 4
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Net income (loss)
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$(75,000)
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$(25,000)
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$30,000
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$90,000
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$160,000
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Mrs. Lucci plans to operate the venture through year 4 before disposing of it in year 5. She is undecided whether to organize the venture as a single-member LLC or to incorporate, but she wants to choose the entity that will maximize NPV of her cash flows.
1) If Mrs. Lucci creates a single-member LLC, she can deduct the business losses without limitation and will pay tax on the business income. Her marginal tax rate (federal and state) over the five-year period will be 40 percent. She will not withdraw any cash from the LLC until year 5 when she will withdraw all accumulated net income at no tax cost. Compute the NPV of Mrs. Lucci’s cash flows (tax savings, tax costs, cash withdrawal) using a 7 percent discount rate.
2) If Mrs. Lucci incorporates, the corporation will pay tax on its annual income based on the corporate rate schedule and will pay no dividends over the five-year period. In year 5, Mrs. Lucci will sell her stock for an amount of cash equal to the corporation’s accumulated after-tax earnings through year 4. She will recognize the entire amount as capital gain taxable at 20 percent. Compute the NPV of her year 5 after-tax cash flow using a 7 percent discount rate.
Based on your computations in parts (a) and (b), should Mrs. Lucci organize the venture as an LLC or a corporation?