Question

Pear, an individual, plans to start a small business, which will operate as a corporation. In year 0, she expects the corporation to generate an ordinary loss of $1,250,000. Subsequently, she expects the corporation to be profitable, projecting ordinary profit of $1,875,000 in year 1 and $3,125,000 in year 2. Pear's personal marginal tax rate on ordinary income is 37%. Assuming a corporate tax rate of 21% and a 10% discount rate, calculate the present value of expected tax costs on the business earnings for the first 3 years of operations if the business does not make an S corporation election. Assume the excess business loss limitation does not apply. Round your discount rate calculations to three decimal places.

Answer 1

The present value of the expected tax costs for the business's first three years of operations without an S corporation election is $899,940, calculated using a corporate tax rate of 21% and a discount rate of 10%.

Step-by-step explanation:

To calculate the present value of expected tax costs for Pear's business for the first three years, we will perform the following steps:

1. Calculate the taxes for each year based on the corporate tax rate of 21%:
2. Year 0: $1,250,000 loss x 21% = $0 tax (since losses do not generate tax costs).
3. Year 1: $1,875,000 profit x 21% = $393,750 tax.
4. Year 2: $3,125,000 profit x 21% = $656,250 tax.
5. Calculate the present value of each year's tax cost using the discount rate of 10%:
6. Year 0: $0 (no tax to discount).
7. Year 1: $393,750 / (1+0.10) = $357,955 (rounded to the nearest dollar).
8. Year 2: $656,250 / (1+0.10)2 = $541,985 (rounded to the nearest dollar).
9. Sum the present values of tax costs for Year 1 and Year 2:
10. $357,955 + $541,985 = $899,940

The total present value of the expected tax costs for the first three years of operations, without making an S corporation election, is $899,940.