Angela and Thomas are planning to start a new business. Thomas will invest cash in the business but not be involved in day-to-day operations. Angela plans to work full-time overseeing business operations.
The two currently project that the business will generate $200,000 of annual taxable income before consideration of any payments to Angela for her services. Both agree that Angela’s services are worth $100,000. Angela and Thomas plan to form a pass-through entity but are unsure whether to choose a partnership or an S corporation. In either case, they will be equal owners of the entity. Given their other sources of income, both Thomas and Angela have a 39.6 percent marginal tax rate on ordinary income. (Ignore any payroll or self-employment tax consequences.)
a. If the business is operated as a partnership, calculate ordinary income allocated to each owner and explain the treatment by the partnership and by Angela of her $100,000 payment for services.
b. If the business is operated as an S corporation, calculate ordinary income allocated to each owner and explain the treatment by the corporation and by Angela of her $100,000 payment for services.
c. Given your analysis above, explain to Angela and Thomas whether and to what extent income tax consequences should control their choice of entity.