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to page 1, where it is added to (or subtracted from) all the taxpayer‟s other income. The net effect of
this is that the sole proprietor will pay tax on the income from this business at his or her highest
marginal rate, which is determined by the amount of income received from this and other sources (see
Exhibit 8.2).
Exhibit 8.2 Individual federal income tax rates.
In Phil‟s case, for example, if his software business netted $100,000 in a particular year, that
amount would be added to the substantial interest and dividend income from his other investments, so
that he would likely owe the Internal Revenue Service (IRS) $35,000 on this income. If Phil‟s
business were run as a separate taxable corporation, the income generated from it would be taxed at
the lowest levels of the tax rate structure, because it would not be added to any other income. For
example, the first $50,000 of income would be taxed at only 15% and the next $25,000 at only 25%
(see Exhibit 8.3).
This argument is turned on its head, however, if a business anticipates losses in the short term.
Using Phil as an example, if his business operated at a $100,000 loss and as a separate taxable entity,
the business would pay no tax in its first year and would be able to net its early losses against profits
only in future years and only if it ever realized such profits. At best, the value of this tax benefit is
reduced by the time value of money; at worst, the loss may never yield a tax benefit if the business
never does better than break even. If Phil operated the business as a sole proprietorship, by contrast,
the loss calculated on his Schedule C would be netted against the dividend and interest income
generated by his investments, thus effectively rendering $100,000 of that income tax free. One can
strongly argue, therefore, that the form in which one should operate one‟s business is dictated, in part,
by the likelihood of its short-term success and the presence or absence of other income flowing to its
owner.
Partnerships