Chapter 1 (13).docx.GRADED A+

Chapter 1 (13).docx.GRADED A+ 1. [LO1] What is meant by the term double taxation of corporate income? The term double taxation refers to the fact that under the U.S. system of taxation, corporate earnings are first taxed when earned by a C corporation and then are taxed a second time when the earnings are distributed to the shareholders as a dividend. 2. [LO1] How does the double taxation of corporate distributions affect whether an individual chooses to operate a business as a C corporation or as flow-through entity?? A distribution of corporate income characterized as a dividend is subject to double taxation, first at the corporate level (21 percent) and then a second time at the shareholder level as a dividend. However, the double tax may be preferable because the tax rate at both levels can substantially below the regular individual tax rate. A distribution from a flowthrough entity is only taxed once but at the regular tax rate (potentially, 37 percent). 3. [LO1] Why might a shareholder who is also an employee prefer receiving a dividend instead of compensation from a corporation? An individual shareholder might prefer a dividend to compensation because, although the dividend is subject to double taxation, both corporate tax rate and the dividend rate can be substantially below the single tax on compensation. For example, the corporate tax rate is 21 percent and the dividend is taxed at 20 percent (ignoring net investment income tax). Whereas,compensation can be taxed at the relatively high ordinary tax rates (37 percent) plus the federal social security (FICA) taxes.. 4. [LO2] What are the three potential tax treatments of a cash distribution to a shareholder? Are these potential tax treatments elective by the shareholder? A cash distribution to a shareholder can be characterized as 1) dividend to the extent of earnings and profits, 2) tax-free return of capital to the extent of the shareholder’s tax basis in the stock, or 3) gain from sale of the stock (capital gain). The tax law (section 301(c)) prescribes the tax treatment of the distribution; it is not elective by the shareholder.