CHAPTER 2: BUSINESS ORGANIZATION AND TAXES*

This version: July 10, 2005

Chapter contents

Overview..............................................................................................................................2
2.1. Different forms of financial organization ....................................................................3
2.2. Personal income taxes in the United States ...............................................................10
2.3. Corporate taxation in the United States .....................................................................15
2.4. Whats betterbeing a corporation or a sole proprietorship?...................................16
Conclusion .........................................................................................................................23
Exercises ............................................................................................................................24
Appendix: Three Excel functions which can simplify tax computations .........................27

This is a preliminary draft of a chapter of Principles of Finance with Excel. 2001 2005 Simon Benninga

(benninga@wharton.upenn.edu ).

PFE, Chapter 2: Business organization and taxes

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Overview
This chapter discusses two inter-related topics which form the background for the rest of
the book: The forms of business organization and the taxation of business income.

Business forms: The simplest form of a business is the sole proprietorship, a business
that is owned by a single person. More complicated forms of business organization are
partnerships, corporations, or limited liability companies.

Section 1 discusses these

various ways of organization and the difference between them.

Business taxation: Taxes are a fact of life. In this book you will learn how to integrate
taxes into optimal financial decision making. As you will see, taxes affect the paybacks
you can expect from assets and hence affect optimal financial decision making. One of
the primary ways in which the organizational form affects a business is in the taxation of
the business income. Sections 2.2 and 2.3 discuss income taxation in the United States.
These sections will show you how income is taxed at both the personal and the corporate
level.

To incorporate or not? Section 2.4 of this chapter compares the taxation of a sole
proprietorship/partnership/limited liability company with the taxation of a corporation.

Finance concepts discussed

Sole proprietorship

Partnership

Corporation

Limited liability company

Shareholders

PFE, Chapter 2: Business organization and taxes

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Taxation

Double taxation of corporate income

Excel functions used

Sum

If

2.1. Different forms of financial organization

The way a business is organized affects its taxes. It also affects the liability situation of
the businesss ownersthe way a business is organized can affect who pays the businesss debts.
In Section 2.1 we discuss briefly four different forms of business ownership: sole
proprietorship, partnership, corporation, and limited liability company.

Sole proprietorship
A sole proprietorship is a business owned by a single person. It is the simplest form of
business organization. From the organizational point of view, a sole proprietorship requires no
paperworkyou simply start your business and thats it.
The income and expenses of a sole proprietorship are reported by the owner on her or his
own personal income tax return. This means that there is no legal separation between the
business and the owner. This lack of legal separation differentiates sole proprietorships from
corporations. It has its good points (simplicity, primarily), but also its bad points. The biggest
disadvantage of the lack of legal separation is that the liabilities of the sole proprietorship are the

PFE, Chapter 2: Business organization and taxes

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personal liabilities of its owner. In principle all of the sole proprietors assets (both personal and
business-related) can be used to pay off the businesss debts.1

Partnership
A partnership is a business owned by two or more people. Usually the partners split the
management and the profits of the business, though there are many exceptions to this rule.
Partnerships are almost as easy to start as sole proprietorships:

They require no formal

paperwork (though many partners wisely choose to record the formalities of ownership,
management and profit sharing).

There are few organizational formalities involved in

partnerships: Although they may choose to elect officers, hold meetings, and make formal
records of business relationships, partnerships are not required by law to do so.
From the tax point of view, the income of a partnership is reported by each of the partners
on their own personal income tax returns.

In the terminology of financial markets, the

partnership income is passed through to the partners. As in the case of a sole proprietorship,
the personal and business-related assets of the partners can be used to pay off the partnership
debts.

Corporation
A corporation is a separate legal entity established for doing business. From a legal
point of view, the corporation is a separate legal person. This means that corporations can

The general rule that in a sole proprietorship there is no distinction between personal and business assets has many

exceptions.

Two typical examples:

In some states, homes up to a certain value are exempt (the so-called

homestead exemption) and personal property up to a certain amount is also exempt (the wildcard exemption).

PFE, Chapter 2: Business organization and taxes

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make contractual arrangements, borrow money, sell shares, and buy other businesses.
Corporations also pay taxes. Whereas neither sole proprietorships nor partnerships can be sued
(you can sue the owners, but not the business, since it has no separate legal standing),
corporations can be sued. On the other hand, the legal liabilities of the corporation do not, in
general, extend to become the liabilities of the corporations owners.
Whereas the organization of a sole proprietorship or a partnership is quite simple, the
organization of a corporation requires some legal formalities. Corporations are separate legal
entities that must be registered in a particular state. The owners of a corporation are called its
shareholders.
The limited liability of a corporation generally means that only the corporations assets
can be claimed in payment for a corporate debt and not the personal assets of the corporations
owners (unless that corporate debt has been personally guaranteed by an owner or employee of
the corporation).

Generally, this limited liability covers all judgments entered against the

corporation, as long as the owners and/or employees involved were acting in their corporate
capacity and without the intention to defraud. Limited liability is the primary reason why
corporate structure is so widespread.

The taxation of corporate income

Corporate income is subject to two levels of taxation: First, income of the corporation is
taxed at the corporate income tax rate.

Then, if shareholders of the corporation are paid

dividends, the shareholders must pay taxes on their dividends at their personal income tax rates.
Heres an example: The Garden family owns Brass Tacks, Inc., a business that makes
picture frames. Estelle Garden and her daughter Terry are the only shareholders of Brass Tacks.

PFE, Chapter 2: Business organization and taxes

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Estelle owns 90% of the shares of Brass Tacks and her daughter Terry owns the other 10% of the
shares.
In 2006 Brass Tacks had a profit before taxes of $1 million. The company pays a
corporate income tax of 35% on this income, leaving it with $650,000 of after-corporate-tax
income. Of this income, the company decided to pay a dividend of $400,000 to its shareholders.
Since Estelle owns 90% of the shares, she got $360,000 of this dividend; Terry got the other
$40,000.
The dividend income received by Estelle and Terry is taxable as personal income. If
Estelles tax rate is 40%, she will end up with $216,000 of after-personal-tax income from the
dividend ( $216,000 = (1-40%)*$360,000 ) . If Terrys personal income tax rate is 25%, she will
have $30,000 of after-personal-tax income from the dividend ( $30,000 = (1-25%)*$40,000 ) .
Theres one other thing to notice about this example: Each of the ownersEstelle and
Terryis taxed twice on her income from the corporation. In section 2.3 we return to this
double taxation of corporate income.

S Corporations and Limited liability companies (LLCs)

S Corporations and limited liability companies combine some features of sole
proprietorships and partnerships with the limited liability enjoyed by corporations. In particular,
both corporate structures maintain the traditional corporations limited liability status, but avoid
the two-tier tax structure of traditional corporations (often called C Corporations).

Corporations and LLCs generally do not pay federal income tax, but instead pass through their
income to the corporations owners, resulting in one level of taxation. Note that LLCs are

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usually more flexible than S corporations, as the latters many restrictions result in compliance
difficulties.

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Forms of business organization

Expenses recognized as
Advantages?
Disadvantages
business costs?
All income is reported as Most expenses
Simplicity. No need for Owner is personally
personal income.
medical, insuranceare registration or other liable for all claims on
not expenses for tax
complex organizational the business.
purposes
details.
Good websites:
http://www.nolo.com/lawcenter/ency/article.cfm/ObjectID/3FD19141-DB91-4FCABDB93416A4D05479/catID/3FED35C1-7BBA-4468-901354F101CBEBE2

Sole proprietorship

http://www.irs.gov/businesses/small/article/0,,id=99336,00.html . This is a good place to look at starting a

small business.

Expenses recognized as Advantages?

Disadvantages
business costs?
Income is split between Most expenses
Simplicity. No need for Owner is personally
the partners and reported medical, insuranceare registration or other liable for all claims on
as personal income.
not expenses for tax
complex organizational the business.
purposes
details.
Good websites:
http://www.nolo.com/lawcenter/ency/article.cfm/ObjectID/D2C7200B-28A8-49FB9EA5E2B7E7F15CB5/catID/DA9428C8-2E99-47F2-A24C1190FE5F24E7#9F61FCB5-91B1-4FBF839BFF095AB1CB8D

Partnerships

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Corporationss
A corporation is a
separate legal entity,
whose income is
separately taxed.

Expenses recognized as Advantages?

business costs?
All the costs of doing
Limited liability.
business are expenses of
the corporation. This
includes employee
medical expenses and
insurance the business
buys for employees.

Disadvantages
Complicated to run and
organize. Two levels of
income taxation
corporate and personal.
Profits which are passed
through to the
corporationss owners
are taxed at the owners
personal tax rates.

Good websites:
http://www.nolo.com/lawcenter/ency/article.cfm/ObjectID/B6061AF8-E1FE-43D9B3117C83BD1CCA82/catID/B491956E-A152-424B-A2342A5861B5EACF

Limited
Liability Expenses recognized as Advantages?
business costs?
Company (LLC)

Disadvantages

Combines the limited

liability feature of
corporations with the
single-tax feature of
corporations.

Though less complicated

to organize and run than
a corporation, a limitedliability company must
be formally organized.

As in the case of a sole

proprietorship, most
LLC expenses are not
recognized for tax
purposes.

Limited liability.
No double taxation of
income. LLC income is
passed through to the
owners and taxed at the
owners personal tax
rates.

Good websites:
http://www.nolo.com/lawcenter/ency/article.cfm/ObjectID/ED01121A-B4BF-498A8BC0DBD121A0C869/catID/BAAE1B67-F54A-41B4-91943A51F56C3F79

Figure 2.1. Forms of business organization

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2.2. Personal income taxes in the United States

This section presents a brief overview of how income taxesboth individual and
corporatework in the United States. If you live in the United States, your income will be
taxed, possibly several times. Your income will certainly be liable to Federal income taxes, and
depending on where you live, it may also be liable to state and local income taxes. This section
presents some insights into the complexities of personal income taxation.

Federal income taxes in the United States

Suppose you live in Nevada, that youre single, and that your taxable income in 2004 was
$32,000. Weve chosen Nevada for this example because it has neither state nor local income
taxes, so that the only taxes due on your income are U.S. Federal taxes. The U.S. tax schedule
for single taxpayers is given in Figure 2.2. Using this tax table, you can compute that you owe
$4,738 in taxes:

Ten percent tax on the first $7,150 of income = $715.

Fifteen percent tax on income between $7,150 and $29,050. This works out to $3,285 =
15% * ($29,050 - $7,150).

Twenty-five percent tax on income over $29,050. As you can see on the tax table, this
income is taxed at a 25% rate. This works out to $738 = 25% * ($32,000 - $29,050) .

PFE, Chapter 2: Business organization and taxes

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U.S. PERSONAL TAX SCHEDULES

FOR SINGLE TAXPAYERS--2004
Taxable income
Over
$0
$7,150
$29,050
$70,350
$146,750
$319,100

But not
over
$7,150
$29,050
$70,350
$146,750
$319,100

Tax rate
10%
15%
25%
28%
33%
35%

On amount
over
$0
$7,150
$29,050
$70,350
$146,750
$319,100

Figure 2.2. U.S. Federal income tax table for a single taxpayer.

This tax calculation can be easily done in Excel, as illustrated in cells B14:B17 below:
A

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20

U.S. FEDERAL INCOME TAX SCHEDULES FOR

SINGLE INDIVIDUALS, 2004
Taxable income
Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Your income

32,000

Tax computation
Tax on first $7,150
Tax on income to $29,050
Tax on income over $29,050
Total tax

$
$
$
$

715
3,285
738
4,738

Average tax rate

Marginal tax rate

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

<-- =10%*7150
<-- =15%*(29050-7150)
<-- =25%*(B11-29050)
<-- =B14+B15+B16

14.80% <-- =B17/B11

25%

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The average tax rate paid is 14.80% (cell B20: 14.80% =

total taxes paid

$4,738
=
).
income
$32,000

The marginal tax rate is the rate paid on the last dollar of income earned; in this example the
marginal tax rate is 25%, the rate that applies to income between $29,050 and $70,350.

State and local income taxes

In the United States the Federal income tax is only part of the story. Almost all states and
many municipalities have their own income tax. In our personal income tax story above, we
purposely picked Nevada as your homethe state of Nevada has no personal income tax and
Nevada localities have no local income tax.
If, instead of Nevada, you lived in Philadelphia, Pennsylvania, you would pay a city wage
tax of 4.4625% and a Pennsylvania state income tax of 2.8%. These state and local income taxes
would amount to $2,324 (cell B5 below). State and local income taxes are subtracted youre
your income before computing your Federal income tax. Your taxable income for Federal taxes
would be $29,676 (cell B6) and your total tax billstate, local, and Federalwould be $6,481
(cell B16).

PFE, Chapter 2: Business organization and taxes

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HOW MUCH WOULD YOU PAY IN TAXES?

Single taxpayer, living in Philadelphia, PA
Income
Philadelphia wage tax
Pennsylvania state income tax
Total state and local taxes
Income liable for federal taxes
Federal income tax
Tax on first $7,150 (10%)
Tax on income to $29,050 (15%)
Tax on income over $29,050 (25%)
Tax on income over $70,350 (28%)
Tax on income over $146,750 (33%)
Tax on income over $319,100 (35%)

$
$
$
$
$

Total federal taxes

Total income taxes paid
Average tax rate

$
$

32,000
1,428
896
2,324
29,676

$
$
$
$
$
$

<-- =4.4625%*B2
<-- =2.8%*B2
<-- =B4+B3
<-- =B2-B5

715 <-- =10%*7150

3,285 <-- =15%*(29050-7150)
157 <-- =25%*(B6-29050)
4,157 <-- =SUM(B8:B13)
6,481 <-- =B15+B5
20.25% <-- =B16/B2

Living in Philadelphia, your average tax rate is 20.25% (cell B17).

If you lived in Philadelphia and your income were $100,000, your average tax rate would
be 27.86%:
A

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HOW MUCH WOULD YOU PAY IN TAXES?

Single taxpayer, living in Philadelphia, PA
Income
Philadelphia wage tax
Pennsylvania state income tax
Total state and local taxes
Income liable for federal taxes
Federal income tax
Tax on first $7,150 (10%)
Tax on income to $29,050 (15%)
Tax on income over $29,050 (25%)
Tax on income over $70,350 (28%)
Tax on income over $146,750 (33%)
Tax on income over $319,100 (35%)

$
$
$
$
$

100,000
4,463
2,800
7,263
92,738

$
$
$
$
$
$

715
3,285
10,325
6,269
-

Total federal taxes

Total income taxes paid
Average tax rate

$
$

20,594 <-- =SUM(B8:B13)

27,856 <-- =B15+B5
27.86% <-- =B16/B2

PFE, Chapter 2: Business organization and taxes

<-- =4.4625%*B2
<-- =2.8%*B2
<-- =B4+B3
<-- =B2-B5
<-- =10%*7150
<-- =15%*(29050-7150)
<-- =25%*(70350-29050)
<-- =28%*(B6-70350)

page 13

Income taxes depend on your filing status

The United States Federal tax regulations admit four different filing statuses:

A single taxpayer is an individual who pays taxes only on his or her own income.

A married individual filing jointly reports the income of herself and her spouse on the
same income tax form.

A married individual filing separately reports only her own income. Her spouse
reports his income separately. The tax rates which apply to a married individual filing
separately are the same as those which apply to a single taxpayer.

A head of household is a taxpayer who supports some other individual. This individual
could be a child, a parent, a spouse, or a non-relative who permanently resides in the
household.
As you can see in Figure 2.3, income tax rates depend on the filing status of the

individual.

PFE, Chapter 2: Business organization and taxes

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4
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14
15
16
17
18
19
20
21

22
23
24
25
26
27
28
29
30
31
32
33
34

Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Income
Tax computation
Tax on first $7,150
Tax on income to $29,050
Income over $29,050
Tax on income over $29,050
Total tax

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Tax rate on
current bracket
10%
15%
25%
28%
33%
35%

715
3,285
2,950
738
4,738

<-- =C5*B5
<-- =C6*(B6-B5)
<-- =B12-B6
<-- =C7*B16
<-- =B14+B15+B17

Married Individuals Filing Jointly

Taxable income
Over
$
$
$
$
$
$

14,300
58,100
117,250
178,650
319,100

Income
Tax computation
Tax on first $14,300
Tax on income over $14,300
Total tax

Tax rate on
current bracket
But not over
$
14,300
10%
$
58,100
15%
$
117,250
25%
$
178,650
28%
$
319,100
33%
35%
$32,000
$
$
$

1,430 <-- =C23*B23

2,655 <-- =C24*(B30-B23)
4,085 <-- =B32+B33

Married Individuals Filing Separately

Taxable income

36
37

$32,000
$
$
$
$
$

Single Taxpayer
Taxable income

2
3

38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55

Over
$
$
$
$
$
$

56
57
58
59
60
61
62
63
64
65
66
67
68

Over
$
$
$
$
$
$

7,150
29,050
58,625
89,325
159,550

Income
Tax computation
Tax on first $7,150
Tax on income to $29,050
Income over $29,050
Tax on income over $29,050
Total tax

Tax rate on
current bracket
But not over
$
7,150
10%
$
29,050
15%
$
58,625
25%
$
89,325
28%
$
159,550
33%
35%
$32,000
$
$
$
$
$

715
3,285
2,950
738
4,738

<-- =C39*B39
<-- =C40*(B40-B39)
<-- =B46-B40
<-- =C41*B50
<-- =B48+B49+B51

Heads of Households
Taxable income
10,200
38,900
100,500
162,700
319,100

Income
Tax computation
Tax on first $10,200
Tax on income over $10,200
Total tax

Tax rate on
current bracket
But not over
$
10,200
10%
$
38,900
15%
$
100,500
25%
$
162,700
28%
$
319,100
33%
35%
$32,000
$
$
$

1,020 <-- =C57*B57

3,270 <-- =C58*(B64-B57)
4,290 <-- =B66+B67

Figure 2.3: Tax tables for 4 kinds of filers in United States, showing taxes payable on $32,000
of annual income. Single taxpayers and married individuals filing separately pay the most tax;
married individuals filing jointly pay the least taxes.

2.3. Corporate taxation in the United States

Corporate taxation in the United States is in some ways similar to personal taxation
there are eight corporate tax brackets, ranging from 15% to 39%, as shown below:

PFE, Chapter 2: Business organization and taxes

page 15

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U.S. FEDERAL INCOME TAX SCHEDULES FOR CORPORATIONS 2004

rates were applicable in 2000-2004
Taxable income over
$
$
$
$
$
$
$
$

50,000
75,000
100,000
335,000
10,000,000
15,000,000
18,333,333

Corporate income
Tax on first $50,000 (15%)
Tax on income over $50,000 less than $75,000 (25%)
Tax on income over $75,000 less than $100,000 (34%)
Tax on income over $100,000 less than $335,000 (39%)
Tax on income over $335,000 less than $10,000,000 (34%)
Tax on income over $10,000,000 less than $15,000,000 (35%)
Tax on income over $15,000,000 less than $18,333,333 (38%)
Tax on income over $18,333,333 (35%)
U.S. corporate income tax

Not over
$
50,000
$
75,000
$
100,000
$
335,000
$ 10,000,000
$ 15,000,000
$ 18,333,333

$
$
$
$
$
$
$
$
$
$

500,000
7,500
6,250
8,500
91,650
56,100
170,000

Average corporate tax rate

Tax rate
15%
25%
34%
39%
34%
35%
38%
35%

<-- =15%*50000
<-- =25%*(75000-50000)
<-- =34%*(100000-75000)
<-- =39%*(335000-100000)
<-- =34%*(500000-335000)

34% <-- =B21/B12

A corporation with $500,000 of annual income (cell B12) pays Federal income taxes of
$170,000. The companys average tax rate is 34% =

170,000
(cell B23).
500,000

The corporate tax rate schedule is designed so that companies with income over
$18,333,333 pay an average tax rate of 35%.

2.4. Whats betterbeing a corporation or a sole proprietorship?

The owner of a corporation has his income taxed twice. His income is first taxed as
corporate income and subsequently, when part of the income is paid out as salary, it is taxed
again as personal income.2 This section discusses this double taxation of corporate income and

In an attempt to be gender inclusive, he and she are used throughout Principles of Finance with Excel in

situations that in fact include people of both genders.

PFE, Chapter 2: Business organization and taxes

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compares it to the taxation of a sole proprietorship, whose income is taxed only at the personal
level.

An example: Rob and Jennifer Smith

Heres an example: Jennifer Smith has a business. Last year Jennifer earned $500,000
from her business, which she reported as a sole proprietorship. As you can see from the
spreadsheet below, Jennifer paid $155,908 Federal income taxes on this income, leaving her with
$344,093 income after taxes.
A

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SINGLE TAXATION: INDIVIDUAL EARNS $500,000 FROM BUSINESS

PAYS TAXES AS SOLE PROPRIETORSHIP
Taxable income
Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

Your income

500,000

Tax computation
Tax on first $7,150 (10%)
Tax on income to $29,050 (15%)
Tax on income to $70,350 (25%)
Tax on income to $146,750 (28%)
Tax on income to $319,100 (33%)
Tax on income over $319,100 (35%)
Total tax

$
$
$
$
$
$
$

715
3,285
10,325
21,392
56,876
63,315
155,908

Net income after taxes

$ 344,093 <-- =B11-B20

<-- =10%*7150
<-- =15%*(29050-7150)
<-- =25%*(70350-29050)
<-- =28%*(146750-70350)
<-- =33%*(319100-146750)
<-- =35%*(B11-319100)
<-- =SUM(B14:B19)

Jennifers brother Rob Smith has the same kind of business, but chose to incorporate.
Robs corporation is called RobSmith, Inc. This means that RobSmith, Inc. first has to pay
corporate income taxes of $170,000 on the $500,000 income (cell B22 below). This leaves
RobSmith, Inc. with $330,000 of after-tax income (B24), which it then pays as a dividend to Rob
PFE, Chapter 2: Business organization and taxes

page 17

Smith. This dividend is liable to Federal personal income taxes. When all is said and done, Rob
will have $233,593 as after-tax income (cell B49 below).

PFE, Chapter 2: Business organization and taxes

page 18

A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26

DOUBLE TAXATION: FIRST CORPORATE INCOME TAX THEN

PERSONAL TAXES
Corporate tax
Taxable income over
$
$
$
$
$
$
$
$

50,000
75,000
100,000
335,000
10,000,000
15,000,000
18,333,333

Not over
$
50,000
$
75,000
$
100,000
$
335,000
$ 10,000,000
$ 15,000,000
$ 18,333,333

Tax rate
15%
25%
34%
39%
34%
35%
38%
35%

Corporate income

$ 500,000

Tax on first $50,000 (15%)

Tax on income over $50,000 less than $75,000 (25%)
Tax on income over $75,000 less than $100,000 (34%)
Tax on income over $100,000 less than $335,000 (39%)
Tax on income over $335,000 less than $10,000,000 (34%)
Tax on income over $10,000,000 less than $15,000,000 (35%)
Tax on income over $15,000,000 less than $18,333,333 (38%)
Tax on income over $18,333,333 (35%)
U.S. corporate income tax

$
$
$
$
$
$
$
$
$

7,500
6,250
8,500
91,650
56,100
170,000

Net after corporate tax

330,000 <-- =B13-B22

27
28

Personal tax

29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49

Over
$
$
$
$
$
$

<-- =15%*50000
<-- =25%*(75000-50000)
<-- =34%*(100000-75000)
<-- =39%*(335000-100000)
<-- =34%*(B13-335000)

<-- =SUM(B14:B21)

Taxable income
7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Your income

Tax computation
Tax on first $7,150 (10%)
Tax on income to $29,050 (15%)
Tax on income to $70,350 (25%)
Tax on income to $146,750 (28%)
Tax on income to $319,100 (33%)
Tax on income over $319,100 (35%)
Total tax

$
$
$
$
$
$
$

Total taxes paid

Net income after all taxes

$ 233,593 <-- =B13-B48

PFE, Chapter 2: Business organization and taxes

330,000 <-- =B24

715
3,285
10,325
21,392
56,876
3,815
96,408

<-- =10%*7150
<-- =15%*(29050-7150)
<-- =25%*(70350-29050)
<-- =28%*(146750-70350)
<-- =33%*(319100-146750)
<-- =35%*(B37-319100)
<-- =SUM(B40:B45)

266,408 <-- =B22+B46

page 19

Double taxation of business income

As you can see, Jennifer Smith is a lot better off than her brother Robher after-tax
income is $110,000 more than Robs. Jennifer pays about half the taxes that Rob pays on his
income.
If incorporation causes the total tax bill of the final beneficiaries of the income to
increase, why incorporate? There are several reasons:

Corporations can take more expenses for tax purposes than individuals. For example, it
may be that Robs corporation can buy him a car and legally report the purchase of the
car as an expense. If Rob has employees, it may be that his corporation can pay for their
child-care expenses and pensions and deduct these payments as an expense. Figure 2.3
shows a large range of corporate expenses which the state of Arizona allows its
corporations.

These expenses are only available to corporations and not to sole

proprietorships.

Corporations can have shareholders. If Rob wants his company to grow and wants to
have many people invest in RobSmith Inc., he will need to become a corporation and
issue shares. Jennifers sole proprietorship is not legally able to sell shares.

Corporations have limited liability.

If RobSmith Inc. gets sued for more than the

corporation is worth, the litigants will not have access to Robs personal propertyhis
house, his car, his investments. On the other hand, if Jennifer gets sued, all her personal
property is fair game.

Corporations have a choice about what to do with their income. RobSmith Inc. can
choose to pay out some of its income as a salary to Rob, and can choose to retain the rest

PFE, Chapter 2: Business organization and taxes

page 20

of the income in the corporation to finance future growth. Only that part of the income
paid out to Rob is subject to double taxation. Jennifer has no such choice.

PFE, Chapter 2: Business organization and taxes

page 21

Corporate Tax Incentives & Credits

The following tax credits apply to corporate
income tax. Arizona has a flat rate corporate
income tax that was lowered in January 2001 to
6.968 percent. Income tax incentive for items
such as construction materials can provide
significant benefit to businesses that are building
or expanding in Greater Phoenix. There are also
a number of programs to benefit and encourage
development of specific types of industries, as
described below

Environmental Technology. A corporation can

claim a tax credit for expenses incurred during
the construction of any qualified environmental
technology
manufacturing
or
processing
facilities. The credit is equal to 10% of the
amount spent in the taxable year. This includes:
land
accusation,
improvements,
building
improvements, machinery, and equipment. The
credit can not exceed 75% of Arizona tax
income liability.

Increased Research Activities. Corporations

may claim a credit for qualified expenses
associated with research conducted in Arizona,
including research conducted at a state
university and funded by the company. For tax
years beginning in 2002, the tax credit cap is
$2,500,000. If the allowable expenses under the
federal regular credit computation method do not
exceed $2,500,000, the allowable credit is 20
percent of this amount. If the allowable
expenses under the federal regular credit
computation method exceed $2,500,000, the
allowable credit amount is $500,000 plus 11
percent of the amount of expenses over
$2,500,000, subject to certain limitations. The
taxpayer may carry forward any unused credit
over the next 15 consecutive taxable years.

Defense Contractors. Qualified defense

contractors may claim tax credits for net
employment increases under defense related
contracts or net employment increases from
transferring jobs from exclusively defense
related activities to commercial activities.

Pollution Control Tax Credit. The purchase of

real or personal property used to control or
prevent pollution is applicable for a 10 percent
income tax credit
Agricultural Pollution Control Equipment. A
taxpayer may claim a credit for 25 percent of the
cost of agricultural pollution control equipment
up to a maximum of $25,000 annually. The
taxpayer must be engaged in agricultural
production, livestock, horticulture, viticulture, or
floriculture.

Military Reuse Zones. The Arizona Legislature

designated the former Williams Air Force Base,
now known as Williams Gateway Airport, as a
Military Reuse Zone. Companies locating within
this zone will have their personal property
classified as class 8, representing an 80 percent
property tax savings, for five years. Additionally,
there exists a transaction privilege tax
exemption for many types of construction
performed for an eligible company located in the
Military Reuse Zone.
Technology Training. Qualified employers are
awarded tax credits for expenses incurred while
providing technology skills training.
The
maximum benefit is $1,500 per employee.
Arizona Enterprise Zones. Firms are eligible
to receive income tax credit for a net increase in
qualified employment positions located within an
enterprise zone, which are determined by the
Arizona Department of Commerce. 35% of the
net new eligible employees must live within the
enterprise zone, and the sale of tangible
personal property at retail can make up no more
than 10% of the activity.

Figure 2.3. Why incorporate? Here is a list of corporate expenses which are valid under the
Arizona tax code. These tax breaks are available only to corporations. Despite the double
taxation of corporate income, it may be worthwhile for a company to incorporate.
http://www.gpec.org/InfoCenter/Topics/Incentives/CorporateIncomeTaxIncentives&Credits.html

PFE, Chapter 2: Business organization and taxes

page 22

Conclusion
Taxes are extremely important. This chapter relates the taxes of businesses to the form of
business organization. At this point you should have a better concept of how the income tax
system works to tax both personal and corporate incomes.

PFE, Chapter 2: Business organization and taxes

page 23

Exercises
1. John Doe leaves in Anycity, Anystate, USA. Mr. Doe works as a vice president in a hightech firm and his annual salary is $125,000. Federal income tax in Anystate is based on the tax
schedules given in Section 2.2. The state income taxes in Anystate depend on the tax bracket:
On income between $0-$15,000, the Anystate tax is 4%
From $15,001 to $30,000, the Anystate tax rate is 6%
Above $30,000, the rate is 8%.
Additionally Mr. Doe has to pay 3.2% for the municipality.
Assuming that Mr. Doe is single, compute his federal, state and local taxes. What will be his net
income?

2. Mr. Doe just turned 55 this year. In Anystate residents between the ages of 55-65 can declare
$20,000 saving for pension without paying income taxes on them. However, the remainder of
the income is fully taxable. Compute Mr. Does taxes, assuming that he saves the $20,000.
What is the tax advantage of his being over 55?

3. In this chapter the tax code for both Nevada and Philadelphia, Pennsylvania is specified.
Calculate the difference in tax payment between Nevada and Philadelphia for different earning
levels (at least three).

4. The ABC corporation had last year total profit of $25,000,000. Calculate the tax payment
of the company, according to the Federal corporate tax brackets in Section 2.3.

PFE, Chapter 2: Business organization and taxes

page 24

5.

Assume that you earn $25,000,000 annually (lucky you!).

Compute your Federal tax

payments, assuming no state or local taxes. Compare these payments to the Federal corporat tax
payment you computed in the previous question. How do you explain the fact that the tax
payments are similar although the tax brackets are different?

6.

After finishing your Ph.D. in finance you decided to open a consulting business for

companies in Nevada. According to your estimation your annual income will be $200,000 in the
first few years. You are considering two options being a corporation or a sole proprietorship.
Your accountant estimated that being a corporation will able you to register an additional
$30,000 as expenses. Calculate in which alternative you will pay less tax.

7. Janice Jane Johnson (JJJ) is a famous writer living in Nevada. Each six years JJJ finishes a
new novel, which she then sells to her publisher for the sum of $750,000. Until now JJJ was a
sole proprietorships, but her accountant has advised her to become a corporation.

The

accountant argues that there are two advantages to this move:

JJJ can write off $25,000 annually as additional expenses.

JJJ can smooth her income over the six years cycle (meaning $125,000
annually) thus enjoying lower tax brackets.

In which alternative JJJ will pay fewer total taxes over the six year span?

8. Go back to Estelle and Terry, the owners of Brass Tacks (section 2.1). Estelle owns 90% of
the shares, and Terry owns the rest. Brass Tacks has a tax rate of 35%, Estelle has a tax rate of
40% on her dividend income, and Terry has a tax rate of 25%. Suppose Brass Tacks pays out all

PFE, Chapter 2: Business organization and taxes

page 25

its after-tax profits as dividends. What are the total taxes (corporate + personal) that Estelle and
Terry pay on their dividend? What is the total tax rate of each?

PFE, Chapter 2: Business organization and taxes

page 26

Appendix: Three Excel functions which can simplify tax computations

In this appendix we explain how you can use three Excel functions to automate the tax
computations in this chapter. The three functions are Sum, If, and VLookup. By combining
two If statements, you can write a clever little spreadsheet which completely automates the
income tax computations. A somewhat more complicated use of Excel (which you can skip on
first reading) involves VLookup. By using this function you can simplify the tax computation
even further.

Sum
The Excel function Sum adds a series of numbers. We have used this function to add a
series of numbers, as in the example below:
A

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17

U.S. FEDERAL INCOME TAX SCHEDULES FOR

SINGLE INDIVIDUALS, 2004
Taxable income
Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Your income

32,000

Tax computation
Tax on first $7,150
Tax on income to $29,050
Tax on income over $29,050
Total tax

$
$
$
$

715
3,285
738
4,738

<-- =10%*7150
<-- =15%*(29050-7150)
<-- =25%*(B11-29050)
<-- =SUM(B14:B16)

In Cell B17 we have used the Sum function instead of the simple addition
=B14+B15+B16.
PFE, Chapter 2: Business organization and taxes

page 27

If
The Excel function If allows you to condition your answer in a particular cell based on
other information.
Heres an example: WeNeverCrash Airlines is running a youth special on airfares
from St. Louis to Chicago. If youre under 23, you can get a standby fare for $75, whereas the
regular fare on the route is $200. In the spreadsheet below we use the If function to compute
your fare:
A

USING EXCEL'S IF FUNCTION

do you get the youth airfare discount?

1
2 Your age
3 Your airfare from St. Louis to Chicago

25
200 <-- =IF(B2<23,75,200)

The structure of If is as follows:

If(question, result if answer to question is yes, result if answer to question is no)
In our case the question is is your age (cell B2) < 23? If the answer is yes, then the fare is
75; if the answer is no, then the fare is 200.
A

USING EXCEL'S IF FUNCTION

do you get the youth airfare discount?

1
2 Your age
3 Your airfare from St. Louis to Chicago
4
5
6 =IF(B2<23,75,200)
7
8
Is your age (cell B2) less than 23?
9
10
Age < 23, airfare = 75
11
Age > 23, airfare = 200
12

PFE, Chapter 2: Business organization and taxes

25
200 <-- =IF(B2<23,75,200)

page 28

Using the If function to compute taxes

We can use Excels If function to compute taxes. In the spreadsheet below, weve used
two If statements to compute the tax in each tax bracket. Its a bit complicated, but worth the
effort (for a discussion of the programming, see the next sub-section).
A

U.S. FEDERAL INCOME TAX SCHEDULES FOR SINGLE INDIVIDUALS, 2004

using Excel's IF function

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Taxable income
Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Your income

32,000

Tax computation
Tax on income to $7,150
Tax on income between $7,150 and $29,050
Tax on income between $29,050 and $70,350
Tax on income between $70,350 and $146,750
Tax on income between $146,750 and $319,100
Tax on income over $319,100
Total tax

$
$
$
$
$
$
$

715
3,285
738
4,738

<-- =IF($B$11<A4,0,IF($B$11>B4,(B4-A4)*C4,($B$11-A4)*C4))
<-- =IF($B$11<A5,0,IF($B$11>B5,(B5-A5)*C5,($B$11-A5)*C5))
<-- =IF($B$11<A6,0,IF($B$11>B6,(B6-A6)*C6,($B$11-A6)*C6))
<-- =IF($B$11<A7,0,IF($B$11>B7,(B7-A7)*C7,($B$11-A7)*C7))
<-- =IF($B$11<A8,0,IF($B$11>B8,(B8-A8)*C8,($B$11-A8)*C8))
<-- =IF($B$11<A9,0,($B$11-A9)*C9)

The advantage of this spreadsheet is that it is completely automatedif you put in the
income in cell B11, the spreadsheet correctly computes the income tax in cell B20. For example,
if taxable income is $100,000, then U.S. Federal taxes are $22,627:

PFE, Chapter 2: Business organization and taxes

page 29

U.S. FEDERAL INCOME TAX SCHEDULES FOR SINGLE INDIVIDUALS, 2004

using Excel's IF function

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Taxable income
Over
$
$
$
$
$
$

7,150.00
29,050.00
70,350.00
146,750.00
319,100.00

Tax rate on
bracket
10%
15%
25%
28%
33%
35%

But not over

$ 7,150.00
$ 29,050.00
$ 70,350.00
$ 146,750.00
$ 319,100.00

Your income

100,000

Tax computation
Tax on income to $7,150
Tax on income between $7,150 and $29,050
Tax on income between $29,050 and $70,350
Tax on income between $70,350 and $146,750
Tax on income between $146,750 and $319,100
Tax on income over $319,100
Total tax

$
$
$
$
$
$
$

715
3,285
10,325
8,302
22,627

<-- =IF($B$11<A4,0,IF($B$11>B4,(B4-A4)*C4,($B$11-A4)*C4))
<-- =IF($B$11<A5,0,IF($B$11>B5,(B5-A5)*C5,($B$11-A5)*C5))
<-- =IF($B$11<A6,0,IF($B$11>B6,(B6-A6)*C6,($B$11-A6)*C6))
<-- =IF($B$11<A7,0,IF($B$11>B7,(B7-A7)*C7,($B$11-A7)*C7))
<-- =IF($B$11<A8,0,IF($B$11>B8,(B8-A8)*C8,($B$11-A8)*C8))
<-- =IF($B$11<A9,0,($B$11-A9)*C9)

How does it work?

The spreadsheet above works by using two If statements. Heres how this works:

Each tax bracket has a lower limit (in column A) and an upper limit (column B). For
example, the first tax bracket has lower limit $0 (cell A4) and upper limit $7,150 (cell
B4).

The first If statement asks whether the income is less than the brackets lower limit. If
the answer is yes, than the tax for this bracket is zero.

If the answer to the first If statement is no, then there is a second If statement. This
statement asks whether the income is greater than the brackets upper limit.
o If the answer to this question is yes, then the tax on the bracket is the bracket
size times the bracket tax rate. For example, if income (cell $B$11) is greater
than $7,150 (cell B4), then the tax on the bracket is 10%*(7150-0)=C4*(B4-A4).

PFE, Chapter 2: Business organization and taxes

page 30

o If the answer to this question is no, then the tax on the bracket is the amount of
income in the bracket times the bracket tax rate. For example, if income (cell
$B$11) is less than $7,150 (cell B4), then the tax on the bracket is
10%*(income 0) = C4*($B$11-A4).

THE LOGIC OF TWO IF STATEMENTS IN THE COMPUTATION OF INCOME TAX

First If statement
Is income (cell B11) less
than the column A cutoff?

Yes

The tax on this bracket is $0

No

Second If statement
Is income (cell B11) greater
than the column B cutoff?

Figure A.1.

Yes

The tax on this bracket is

the tax rate (column C) * total bracket
example: (B4-A4)*C4

No

The tax on this bracket is

the tax rate (column C) * (taxable income - lower end of bracket)
example: (B11-A4)*C4

A graphical representation of the computation of income taxes using two If

statements.

Advanced Excel note: Using VLookup to compute the taxes

If you know a bit more Excel, you can simplify the calculation by using the Excel
function VLookup (see Chapter 29). Heres the tax calculation using VLookup:

PFE, Chapter 2: Business organization and taxes

page 31

A
1
2

3
4
5
6
7
8
9
10
11
12

U.S. FEDERAL INCOME TAX SCHEDULES FOR SINGLE INDIVIDUALS, 2004

Taxable income
Over
But not over
$
$ 7,150.00
$ 7,150.00 $ 29,050.00
$ 29,050.00 $ 70,350.00
$ 70,350.00 $ 146,750.00
$ 146,750.00 $ 319,100.00
$ 319,100.00
Income
Tax

$
$

Tax
Tax rate on
current
bracket
10%
15%
25%
28%
33%
35%

Tax on
previous
brackets
$
$
715.00 <-- =C4*A5
$ 4,000.00 <-- =D5+C5*(A6-A5)
$ 14,325.00 <-- =D6+C6*(A7-A6)
$ 35,717.00
$ 92,592.50

32,000
4,738 <-- =VLOOKUP(B11,A4:D9,4)+VLOOKUP(B11,A4:C9,3)*(B11-VLOOKUP(B11,A4:C9,1))

The advantage of using VLookup is that it enables you to do a concise calculation of the
taxes. Inserting any number into cell B11 above will produce a correct tax calculation in cell
B12. suppose, for example, that your income were $175,000:
A
1
2

3
4
5
6
7
8
9
10
11
12

U.S. FEDERAL INCOME TAX SCHEDULES FOR SINGLE INDIVIDUALS, 2004

Taxable income
Over
But not over
$
$ 7,150.00
$ 7,150.00 $ 29,050.00
$ 29,050.00 $ 70,350.00
$ 70,350.00 $ 146,750.00
$ 146,750.00 $ 319,100.00
$ 319,100.00
Income
Tax

$
$

Tax
Tax rate on
current
bracket
10%
15%
25%
28%
33%
35%

Tax on
previous
brackets
$
$
715.00 <-- =C4*A5
$ 4,000.00 <-- =D5+C5*(A6-A5)
$ 14,325.00 <-- =D6+C6*(A7-A6)
$ 35,717.00
$ 92,592.50

175,000
45,040 <-- =VLOOKUP(B11,A4:D9,4)+VLOOKUP(B11,A4:C9,3)*(B11-VLOOKUP(B11,A4:C9,1))

PFE, Chapter 2: Business organization and taxes

page 32