John Day and Carol Knight conduct similar financial activities. Each is employed and has a portfolio of investments, and during the current year, each started a separate small business. Their financial results for the year ended December 31, 20X1, are identical, as follows:
Employment income…………………………….. $40,000
Interest income from investment portfolio………. 15,000
Loss from new small business operation…………. (20,000)
The only difference between Day and Knight is that Day operated his business as a proprietorship, whereas Knight operated her business from a wholly owned corporation.
Required:
1. Assuming that individual tax rates are 40%, compare the tax liability of Day with that of Knight for 20X1.
2. How and when may Knight utilize her business loss to reduce her tax liability?
3. What impact may the difference in tax treatment have on Day’s and Knight’s wealth accumulation and on their long-term returns on investment?