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Legal Form for Richard and Jack's Business

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. On their investment, they expect to generate 10 percent before-tax return 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 as a C corporation.

1. If they establish a partnership, compute the after-tax cash flow for each partner if each of them withdraws $4,000 from the profits of the business the first year. What is the amount of cash that remains in the partnership, exclusive of employment taxes.

2. 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?

3. What nontax factors should Richard and Jack consider when making this decision?

4. After a detailed analysis, what would you recommend? Do you feel Richard and Jack should establish a partnership or a C corporation?

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Solution Preview

Questions 1 and 2 are answered on the attached excel.

3. The types of non-cash questions the partners/shareholders should ask themselves include

a. are they ready for the formality and expense of setting up a C-corporation?

b. do they understand that the corporation becomes an 'artificial person' under the law and therefore a separate legal entity from themselves

c. do they need the liability protection a corporation can offer to its shareholders?

d. do they understand that they can only draw funds from the corporation as wages or (double-taxed) dividends

e. do they realized that a C corporation has advantages for growth potential with the addition of investors who can remain passive (not involved in daily operations). This is a control issue.

f. they should understand the formality of liquidation of a ...

Solution Summary

This problem is a relatively complex comparison of a partnership as opposed to a corporate form. Not only is tax calculated, but nine other business issues are discussed in response to question 3. Further discussed is the possibility of becoming an "S" corporation.