Richard plans to invest $100,000 for a 50 percent interest in a small business. His friend Jack will also invest $100,000 for the remaining 50 percent interest. They expect to generate a 10 percent before-tax return on their investment the first year. Richard's marginal tax rate is 33 percent and Jack's marginal tax rate is 35 percent. They need to decide whether to establish the business as a partnership or a C corporation.
a. If they establish a partnership, compute the after-tax cash flow for each partner if each of them withdraws $4,000 of the profits from the business the first year. What is the amount of cash that remains in the partnership? (Ignore employment taxes.)
b. If they establish a C corporation, compute the after-tax cash flow for each shareholder if each of them receives a dividend of $4,000 from the profits of the business the first year.
What is the amount of cash that remains in the C corporation?
c. What nontax factors should Richard and Jack consider in making this decision?
d. What do you recommend?
e. How would your answers change if you consider the impact of employment taxes in your solutions?