Jayzee is a single taxpayer who operates a sole proprietorship. He expects his taxable income next year to be $150,000, of which $125,000 is attributed to his sole proprietorship. Jayzee is contemplating incorporating his sole proprietorship. Using the 2019 single individual tax brackets and the corporate tax brackets, how much current tax could this strategy save Jayzee? (Ignore any Social Security, Medicare, or self-employment tax issues.) How much income should be retained in the corporation? (Use tax rate schedule)
What will be an ideal response?
Assuming Jayzee's goal is to minimize his current federal income tax exposure, one can compare the single individual and corporate tax rate schedules to achieve this goal. Since Jayzee has $25,000 of taxable income not related to his sole proprietorship, he is currently in the 12 percent tax bracket. The task is to allocate the $125,000 between Jayzee and his corporation to minimize his current liability. The corporate tax rate is 21 percent and is higher than Jayzee's marginal tax rate of 12 percent. To take advantage of the remaining $14,475 of the 12 percent individual tax bracket ($39,475 ? $25,000), $14,475 of the profits should be shifted to Jayzee. Jayzee's personal marginal tax rate would now be 22 percent, and his corporation's marginal tax rate of 21 percent is now lower. To minimize this year's taxes, the remaining $110,525 of corporate profits should be retained in the corporation and taxed at 21 percent. In sum, $110,525 of the expected profits are retained in the corporation and $14,475 of the profits are shifted to Jayzee.
This strategy will save Jayzee $2,423.50, calculated as:
| (a) | The tax on $150,000 of taxable income reported by Jayzee, assuming that he operates his business as a sole proprietorship | $ | 30,174.50 |
| Less: | |||
| (b) | The tax on $39,475 of taxable income reported by Jayzee, assuming that he incorporates his business | -$ | 4,543.00 |
| (c) | The tax on $110,525 profits retained in the corporation | -$ | 23,210.25 |
| =$ | 2,421.25 | ||
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