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Question:
Sarah plans to invest $1 million in a business venture that will last five years. She is debating whether to operate the business as a C corp or a sole proprietorship. If a C corp, she can liquidate the corporation at the end of the five-year period. She expects the business to prepare taxable income as follows:
year 1: 40,000, year 2: 70,000, year 3: 90,000, year 4: 150,000, year 5: 350,000.
If incurred in corporate form, these taxable income amounts will be subject to the corporate tax rate schedule. If in proprietorship form, they can be subject to Sarah's 35% marginal tax rate. Consider that any capital gain upon corporate liquidation will be taxed at a 23.8% capital gains rate (including the 3.8% net investment tax rate) and that sec. 1202 does not apply.
Required:
Evaluate the after-tax amount Sarah will have at the end of five years under each alternative. Which alternative do you recommend?
Discuss the similarities and differences between the tax consequences of the operating distribution and the tax consequences of the liquidation distribution.
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