ACC10007 Lecture Notes - Lecture 3: Sole Proprietorship, Financial Statement, Accounts Payable
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Tax Strategies for Business Planning andInvestment
Tax Planning Case II: Entity Selection
We’ve received an inquiry from a client and we’d like you todraft a memorandum indicating how we should respond to these clientinquiries. The inquiry concerns the formation of a business and ouranalysis of the impact various entity types might have on thebusiness.
Please format your memorandum to Identify significant tax andnontax issues or concerns that may differ across entity types anddiscuss how they are relevant to the choice of entity decision forthe client’s business. Include a brief summary of the inquiry, youranalysis of the inquiry, the issues posed, any relevantcomputations and your recommendations. Please include yourcomputations directly in your memorandum and do not attach them ina separate Excel spreadsheet.
Please format the memorandum as follows:
MEMORANDUM
To: Eugene Kilo, Smith TaxConsultants
From: [Team members, provide your own titles]
Re: Various Tax Matters
Date: [Applicable Date]
Martha Taylor is currently employed by the Maryland Chamber ofCommerce. While she enjoys the relatively short workweeks, sheeventually would like to work for herself rather than for anemployer. In her current position, she deals with a lot ofsuccessful entrepreneurs who have become role models for her.Martha has also developed an extensive list of contacts that shouldserve her well when she starts her own business.
It has taken a while but Martha believes she has finallydeveloped a viable new business idea. Her idea is to design andmanufacture cookware that remains cool to the touch when in use.She has had several friends try out her prototype cookware and theyhave consistently given the cookware rave reviews. With thisencouragement, Martha started giving serious thoughts to making“Cool Touch Cookware” (CTC) a moneymaking enterprise.
Martha had enough business background to realize that she isembarking on a risky path, but one, she hopes, with significantpotential rewards down the road. After creating some initial incomeprojections, Martha realized that it will take a few years for thebusiness to become profitable. After that, she hopes the sky’s thelimit. She would like to grow her business and perhaps at somepoint “go public” or sell the business to a large retailer. Thiscould be her ticket to the rich and famous.
Martha, who is single, decided to quit her job with the stateChamber of Commerce so that she could focus all of her efforts onthe new business. Martha had some savings to support her for awhile but she did not have any other source of income. Martha wasable to recruit Linda and Mike to join her as initial equityinvestors in CTC. Linda has an MBA and a law degree. She wasemployed as a business consultant when she decided to leave thatjob and work with Martha and Mike. Linda’s husband earns around$300,000 a year as an engineer (employee). Mike owns avery profitable used car business. Because buying andselling used cars takes all his time, he is interested in becomingonly a passive investor in CTC. He wanted to get in on the groundfloor because he really likes the product and believes CTC will bewildly successful. While CTC originally has three investors, Marthaand Linda have plans to grow the business and seek more owners andcapital in the future.
The three owners agreed that Martha would contribute land andcash for a 30 percent interest in CTC, Linda would contributeservices (legal and business advisory) for the first two years fora 30 percent interest, and Mike would contribute cash for a 40percent interest. The plan called for Martha and Linda to beactively involved in managing the business while Mike would notbe.
The three equity owners’ contributions are summarized asfollows:
Martha Contributed | FMV | Adjusted Basis | Ownership Interest |
Land (held as investment) | $120,000 | $70,000 | 30% |
Cash | $30,000 | ||
Linda Contributed | |||
Services | $150,000 | 30% | |
Mike Contributed | |||
Cash | $200,000 | 40% |
Working together, Martha and Linda made the following five-yearincome and loss projections for CTC. They anticipate the businesswill be profitable and that it will continue to grow after thefirst five years.
| Cool Touch Cookware 5-Year Income and Loss Projections | ||||||||||||
|
With plans for Martha and Linda to spend a considerable amountof their time working for and managing CTC, the owners would liketo develop a compensation plan that works for all parties. Down theroad, they plan to have two business locations (in differentcities). Martha would take responsibility for the activities of onelocation and Linda would take responsibility for the other.Finally, they would like to arrange for some performance-basedfinancial incentives for each location.
To get the business activities started, Martha and Lindadetermined CTC would need to borrow $800,000 to purchase a buildingto house its manufacturing facilities and its administrativeoffices (at least for now). Also in need of additional cash, Marthaand Linda arranged to have CTC borrow $300,000 from a local bankand to borrow $200,000 cash from Mike. CTC would pay Mike a marketrate of interest on the loan but there was no fixed date forprincipal repayment.
