AC312 - Tax Research Memo #1

Your friend Millie is starting a new business venture with her best friend Bob, and you have agreed to provide tax consulting services on an as-needed basis.Millie and Bob plan to name the company Oh Gnome You Didn't ("Gnome"), although they haven't yet decided on the type of legal entity for the business.

The business plan is for Gnome to design and construct whimsical gnome gardens for its clientele.Millie will manage Gnome's operations full-time as an employee in exchange for reasonable compensation.

Unfortunately, Bob has gnomophobia, better known as the fear of garden gnomes (it's a real thing).Therefore, Bob intends to stay far away from Gnome's gnomes, and will not participate in Gnome's day-to-day operations.

Millie would prefer to incorporate Gnome as a C-corporation because the new 21% corporate tax rate is much lower than her individual marginal tax rate of 35%.Bob would also like to incorporate Gnome, but he wants to avoid double taxation on shareholder distributions; therefore, his preference is for Gnome to make an election to be an S-corporation in its initial tax year.

Millie and Bob are currently modeling the after-tax return impact of choosing a C-corporation versus an S-corporation, and they have requested your assistance to help them understand some confusing tax rules.Their specific questions they need your advice on are as follows:

1."We've heard something about a new tax law that lets you deduct 20% of your income, but we've also been told that the deduction isn't available to all businesses.Will Gnome's income qualify for this deduction if (A) it is a C-corporation or (B) it is an S-corporation?"

2."We're also unsure about the 3.8% net investment income tax on individuals.Will either of us be liable for this tax if (A) Gnome is a C-corporation or (B) Gnome is an S-corporation?"

3."We're worried about messing up the election if we decide that Gnome should be an S-corporation.When exactly does our S-corporation election have to be made if we want to ensure Gnome will be treated as an S-corporation beginning with its initial tax year?"

Supplementary Information

Millie is a single taxpayer, and her adjusted gross income ("AGI") is estimated at $100,000.

Bob is married and files a joint tax return with his wife; together their AGI is estimated at $425,000.