The Role of Managerial Lecture Note 5

Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (1 of 2) blank Sole proprietorship Partnership Corporation Strengths • Owner receives all profits (and sustains all losses) • Low organizational costs • Income included and taxed on proprietor’s personal tax return • Independence • Secrecy • Ease of dissolution • Can raise more funds than sole proprietorships • Borrowing power enhanced by more owners • More available brain power and managerial skill • Income included and taxed on partner’s personal tax return • Owners have limited liability, which guarantees that they cannot lose more than they invested • Can achieve large size via sale of ownership (stock) • Ownership (stock) is readily transferable • Long life of firm • Can hire professional managers • Has better access to financing Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (2 of 2) blank Sole proprietorship Partnership Corporation Weaknesses • Owner has unlimited liability in that total wealth can be taken to satisfy debts • Limited fund-raising power tends to inhibit growth • Proprietor must be jackof-all-trades • Difficult to give employees long-run career opportunities • Lacks continuity when proprietor dies • Owners have unlimited liability and may have to cover debts of other partners • Partnership is dissolved when a partner dies • Difficult to liquidate or transfer partnership • Taxes are generally higher because corporate income is taxed, and dividends paid to owners are also taxed at a maximum 15% rate • More expensive to organize than other business forms • Subject to greater government regulation • Lacks secrecy because regulations require firms to disclose financial results Matter of Fact (1 of 2) Number of Businesses and Income Earned by Type of U.S. Firm Although sole proprietorships greatly outnumber partnerships and corporations combined, they generate the lowest level of income. In total, sole proprietorships accounted for almost three-quarters of the number of business establishments in operation, but they earned just 10% of all business income. Corporations, on the other hand, accounted for just 17% of the number of businesses, but they earned almost two-thirds of all business income. Matter of Fact (2 of 2) blank Sole proprietorships Partnerships Corporations Number of firms (millions) 25.3 3.4 5.8 Percentage of all firms 73% 10% 17% Percentage of all business income 10% 26% 64% Source: Overview of Approaches to Corporate Integration, Joint Committee on Taxation, United States Congress, May 17, 2016. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (6 of 13) • Business Organizational Forms and Taxation • Prior to 2018 – Proprietorships and partnerships taxed according to the same progressive rate structure as individual taxpayers – Corporations taxed according to an alternative, mostly progressive rate structure • Marginal vs. Average Tax Rate  The marginal tax rate represents the rate at which the next dollar of income is taxed while the average tax rate equals taxes paid divided by taxable income  The marginal rate does not usually equal the average rate under a progressive tax rate structure 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (7 of 13) • Business Organizational Forms and Taxation • After 2018 (Tax Cuts and Jobs Act 2017) – Proprietorships and partnerships still taxed according to a (revised) progressive rate structure – Corporations taxed at a flat rate of 21% – Under a flat tax, the marginal and average tax rates are equal 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (8 of 13) • Legal Forms of Business Organizations – Business Organizational Forms and Taxation  Double Taxation – A situation facing corporations in which income from the business is taxed twice—once at the business level and once at the individual level when cash is distributed to shareholders  Ordinary Income versus Capital Gains – Ordinary income is income earned by a business through the sale of goods or services while capital gains is income earned by selling an asset for more than it cost Table 1.2 2018 Tax Rate Schedule for Single Taxpayer (Tax Rates Faced by Pass-Through Businesses Like Proprietorships and Partnerships) Tax calculation Base tax + (Marginal rate × amount over bracket lower limit) $ 0 to $ 9,525 $ 0 + (10% × amount over $ 0) 9,525 to 38,700 $ 953 + (12% × amount over $ 9,525) 38,700 to 82,500 $ 4,454 + (22% × amount over $ 38,700) 82,500 to 157,500 $ 14,090 + (24% × amount over $ 82,500) 157,500 to 200,000 $ 32,090 + (32% × amount over $157,500) 200,000 to 500,000 $ 45,690 + (35% × amount over $200,000) $150,690 + (37% × amount over $500,000) Taxable income brackets Over 500,000 Pre-2018 Corporate Tax Rate Schedule Tax calculation Taxable income brackets Base tax + (Marginal rate × amount over bracket lower limit) $ 0 to $ 50,000 $0 + (15% × amount over $ 0) 50,000 to 75,000 $ 7,500 + (25% × amount over $ 50,000) 75,000 to 100,000 $ 13,750 + (34% × amount over $ 75,000) 100,000 to 335,000 $ 22,250 + (39% × amount over $ 100,000) 335,000 to 10,000,000 $ 113,900 + (34% × amount over $335,000) 10,000,000 to 15,000,000 $3,400,000 + (35% × amount over $10,000,000) 15,000,000 to 18,333,333 $5,150,000 + (38% × amount over $15,000,000) $6,416,667 + (35% × amount over $18,333,333) Over 18,333,333 Example 1.5 (1 of 2) Dan Webster is the sole proprietor of Webster Manufacturing. This year Webster earned $80,000 before taxes from his business. Assuming that Dan has no other income, the taxes he will owe on his business income are as follows: Total taxes due = (0.10 × $9,525) + [0.12 × ($38,700 − $9,525)] + [0.22 × ($80,000 − $38,700)] = $953 + $3,501 + $9,086 = $13,540 Example 1.5 (2 of 2) Notice that Webster’s tax liability has two components. The first $4,454 in tax, denoted in Table 1.2 as the base tax, is calculated by multiplying 10% times Webster’s first $9,525 in income and then multiplying 12% times Webster’s next $29,175 in income. The sum of those two calculations is the $4,454 base tax from line 3 in Table 1.2. On top of that, Webster must pay an additional 22% in taxes on income above $38,700.