Assume the corporation in Problem I:18-29 had been an S corporation for its first 12 years, during which it distributed just enough cash for the shareholder to pay taxes on the flow-through income. Thus, the S corporation reinvested after-tax income. Now the corporation is considering revoking its S election and operating as a C corporation for the remaining 20 years with no dividend distributions. Show the results of remaining an S corporation versus revoking the election. Also show supporting models and calculations. Which alternative should the corporation adopt? Ignore the accumulated earnings tax for C corporations. How does your answer change if the C corporation’s tax rate is 15% instead of 35%?

In Problem

Twelve years ago, your client formed a C corporation with a $100,000 investment (contribution). The corporation’s BTROR (R_c) has been and will continue to be 10%. The corporate tax rate (t_c) has been and will continue to be 35%. The corporation pays no dividends and reinvests all after-tax earnings in its business. Thus, the corporation’s value grows at its ATROR. Your client’s marginal ordinary tax rate (t_p) has been 33%, and her capital gains rate has been 15%. Your client expects her ordinary tax rate to drop to 25% at the beginning of this year and stay at that level indefinitely. Her capital gains tax rate will remain at 15%. Assume the corporate stock does not qualify for the Sec. 1202 exclusion for gain on the sale of small business stock. Your client wants you to consider three alternatives:
(1) Continue the business in C corporation form for the next 20 years and liquidate at that time (32 years in total).
(2) Liquidate the C corporation at the end of the 12-year period, invest the after-tax proceeds in a sole proprietorship, and operate as a sole proprietorship for the next 20 years.
(3) Make an S corporation election effective at the beginning of this year, operate as an S corporation for the next 20 years, and liquidate the S corporation at that time (32 years in total).
Regarding Alternatives 2 and 3, the sole proprietorship’s or S corporation’s BTROR (R_p) also will be 10% for the next 20 years. Earnings from the sole proprietorship or S corporation will be taxed currently at your client’s ordinary tax rate, and your client will withdraw just enough from the business to pay her taxes. The remaining after-tax earnings will remain in the business until the end of the investment horizon (20 years from now). Show the results of each alternative along with supporting models and calculations. Which alternative should your client adopt? Ignore the accumulated earnings tax for C corporations.