New Business is just being formed by 10 investors, each of whom will own 10% of the business. The firm is expected to earn $1,200,000 before taxes each year. The corporate tax rate is 34% and the personal tax rate for the firm's investors is 35%. The firm does not need to retain any earnings, so all of its after-tax income will be paid out as dividends to its investors. The investors will have to pay personal taxes on whatever they receive. How much additional spendable income will each investor have if the business is organized as a partnership rather than as a corporation?

a. $20,384

b. $20,800

c. $21,225

d. $21,658

The answer is: Each investor would have an additional $26,520 if the business is organized as a partnership rather than as a corporation.

Explanation:

If the company is taxed as a corporation, we multiply the expected earnings by the tax rates applicable, both corporate and personal taxes:

[$1,200,000 x (1 - 34%) Corp. tax rate x (1 - 35%) personal tax rate] / 10 investors =

($1,200,000 x 66% x 65%) / 10 = $51,480 is the amount each investor will earn after taxes as a corporation

If the company is taxed as a partnership, we multiply the expected earnings by the personal tax rate:

[$1,200,000 x (1-35%) personal tax rate] / 10 investors =

($1,200,000 x 65%) / 10 = $78,000 is the amount each investor will earn after taxes as a partnership

Then we just subtract the expected earnings after taxes as a corporation from the expected earnings as a partnership:

$78,000 - $52,480 = $26,520