Adam, Linda, and Mike are considering starting a bakery togetherin Burlington, VT called Vermont Bakes. They have come to youlooking for advice on the advantages and disadvantages of eachbusiness entity. Adam and Linda will each own 40% of the businessand Mike will own 20%. Adam would like to contribute cash of$40,000, Linda will contribute land with an FMV of $60,000 and anadjusted basis of $25,000. Mike will contribute services of$20,000. In addition, Linda receives $20,000 of cash. Adam, Linda& Mike have indicated that they would like to takedistributions of profits from Vermont Bakes each year in additionto compensation. They plan to pay themselves compensation of$45,000 each and they project that Vermont Bakes will have $10,000in profits each year that they would like to distribute based ontheir ownership percentages. The distributions are as follows:Adjusted Basis FMV Adam - Equipment $2,000 $4,000 Linda - Cash$4,000 $4,000 Mike - Cash $2,000 $2,000 In a concise, well-writtenessay (do not use bullet points - write out your answers inparagraph form): ⢠Explain the advantages and disadvantages of eachentity type (C Corporation, S Corporation, Partnership/LLC),including both tax and non-tax considerations we discussed inclass. Include in your discussion an explanation of entities aretaxed at the entity level and which offer flow through taxation.Explain how are income and losses aggregated when they flow throughto the shareholder/member/partner including the effect this has onthe owner's basis in the entity (if any). ⢠Explain the taxtreatment of property contributions from theshareholder/member/partner to each type entity upon formation.including a discussion of the basis the entity would take in thecontributed property and the basis the shareholder/member/ownerwould have in the entity as a result of the contribution. oCalculate Adam, Linda & Mike's basis in their ownershipinterest if they were part of a prearranged plan to incorporateVermont Bakes as a C corporation. Calculate the basis the Ccorporation would take in the property contributed by Adam, Linda& Mike. Calculate the realized and recognized gain to Adam,Linda & Mike on their contribution to the C corporation (ifany). o Calculate Adam, Linda & Mike's basis in their ownershipinterest if they decided to form Vermont Bakes as a partnership.Calculate the basis the partnership would take in the propertycontributed by Adam, Linda & Mike. Calculate the realized andrecognized gain to Adam, Linda & Mike on their contribution tothe partnership (if any). ⢠Explain the tax treatment of cash andproperty distributions/dividends to a shareholder/member/partner ofeach type of entity. Include in your discussion an explanation ofthe concepts of E&P and AAA and the purpose of thosecalculations. o Calculate Adam's basis in the distributed propertyassuming Vermont Bakes is a C Corporation and indicate whether theproperty distribution would result in gain or loss recognition.Assume Adam's basis just prior to the distribution was $1,000.Would your answer change if this was a liquidating distribution? oCalculate Adam's basis in the distributed property assuming VermontBakes is a partnership and indicate whether the propertydistribution would result in gain or loss recognition. AssumeAdam's basis just prior to the distribution was $1,000. Would youranswer change if this was a liquidating distribution? ⢠ProvideVermont Bakes with a recommendation on which entity you think wouldbest suit their needs including the justification for yourrecommendation.
Adam, Linda, and Mike are considering starting a bakery togetherin Burlington, VT called Vermont Bakes. They have come to youlooking for advice on the advantages and disadvantages of eachbusiness entity. Adam and Linda will each own 40% of the businessand Mike will own 20%. Adam would like to contribute cash of$40,000, Linda will contribute land with an FMV of $60,000 and anadjusted basis of $25,000. Mike will contribute services of$20,000. In addition, Linda receives $20,000 of cash. Adam, Linda& Mike have indicated that they would like to takedistributions of profits from Vermont Bakes each year in additionto compensation. They plan to pay themselves compensation of$45,000 each and they project that Vermont Bakes will have $10,000in profits each year that they would like to distribute based ontheir ownership percentages. The distributions are as follows:Adjusted Basis FMV Adam - Equipment $2,000 $4,000 Linda - Cash$4,000 $4,000 Mike - Cash $2,000 $2,000 In a concise, well-writtenessay (do not use bullet points - write out your answers inparagraph form): ⢠Explain the advantages and disadvantages of eachentity type (C Corporation, S Corporation, Partnership/LLC),including both tax and non-tax considerations we discussed inclass. Include in your discussion an explanation of entities aretaxed at the entity level and which offer flow through taxation.Explain how are income and losses aggregated when they flow throughto the shareholder/member/partner including the effect this has onthe owner's basis in the entity (if any). ⢠Explain the taxtreatment of property contributions from theshareholder/member/partner to each type entity upon formation.including a discussion of the basis the entity would take in thecontributed property and the basis the shareholder/member/ownerwould have in the entity as a result of the contribution. oCalculate Adam, Linda & Mike's basis in their ownershipinterest if they were part of a prearranged plan to incorporateVermont Bakes as a C corporation. Calculate the basis the Ccorporation would take in the property contributed by Adam, Linda& Mike. Calculate the realized and recognized gain to Adam,Linda & Mike on their contribution to the C corporation (ifany). o Calculate Adam, Linda & Mike's basis in their ownershipinterest if they decided to form Vermont Bakes as a partnership.Calculate the basis the partnership would take in the propertycontributed by Adam, Linda & Mike. Calculate the realized andrecognized gain to Adam, Linda & Mike on their contribution tothe partnership (if any). ⢠Explain the tax treatment of cash andproperty distributions/dividends to a shareholder/member/partner ofeach type of entity. Include in your discussion an explanation ofthe concepts of E&P and AAA and the purpose of thosecalculations. o Calculate Adam's basis in the distributed propertyassuming Vermont Bakes is a C Corporation and indicate whether theproperty distribution would result in gain or loss recognition.Assume Adam's basis just prior to the distribution was $1,000.Would your answer change if this was a liquidating distribution? oCalculate Adam's basis in the distributed property assuming VermontBakes is a partnership and indicate whether the propertydistribution would result in gain or loss recognition. AssumeAdam's basis just prior to the distribution was $1,000. Would youranswer change if this was a liquidating distribution? ⢠ProvideVermont Bakes with a recommendation on which entity you think wouldbest suit their needs including the justification for yourrecommendation.
Related questions
Tax Strategies for Business Planning andInvestment
Tax Planning Case II: Entity Selection
Weâve received an inquiry from a client and weâd 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 clientâs 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 makingâCool Touch Cookwareâ (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 skyâs thelimit. She would like to grow her business and perhaps at somepoint âgo publicâ 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. Lindaâs 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 ownersâ 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 | ||||||||||||
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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.
Barry Potter and Winnie Weasley are considering making an Selection on March 1, 2015, for their C corporation, Omniocular.However, first they want to consider the implications of thefollowing information: (Round your intermediate dollarcalculations and final answer to the nearest whole dollaramount.) |
| ⢠| Winnie is a U.S. citizen andresident. |
| ⢠| Barry is a citizen of the UnitedKingdom, but a resident of the United States. |
| ⢠| Barry and Winnie each own 50 percent of the voting power inOmniocular. However, Barryâs stock provides him with a claim on 60percent of the Omniocular assets in liquidation. |
| ⢠| Omniocular was formed under Arizona state law, but it plans oneventually conducting some business in Mexico. |
| a. | Is Omniocular eligible to elect S corporation status? | ||||
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For the remainder of the problem, assume Omniocular made a validS election effective January 1, 2015. Barry and Winnie each own 50percent of the voting power and have equal claim on Omniocularâsassets in liquidation. In addition, consider the followinginformation: |
| ⢠| Omniocular reports on a calendar tax year. |
| ⢠| Omniocularâs earnings andprofits as of December 31, 2014, were $55,000. |
| ⢠| Omniocularâs 2014 taxable incomewas $15,000. |
| ⢠| Omniocularâs assets at the endof 2014 are as follows: |
| Omniocular Assets December 31, 2014 | |||||
| Asset | Adjusted Basis | FMV | |||
| Cash | $ | 50,000 | $ | 50,000 | |
| Accountsreceivable | 20,000 | 20,000 | |||
| Investments instocks and bonds | 700,000 | 700,000 | |||
| Investment inland | 90,000 | 100,000 | |||
| Inventory(LIFO) | 80,000* | 125,000 | |||
| Equipment | 40,000 | 35,000 | |||
| Totals | $ | 980,000 | $ | 1,030,000 | |
| *$110,000 under FIFOaccounting. |
| ⢠| On March 31, 2015, Omniocularsold the land for $42,000. |
| ⢠| In 2015, Omniocular sold all the inventory it had on hand at thebeginning of the year. This was the only inventory it sold duringthe year. |
| Other Income/Expense Items for 2015 | ||
| Sales revenue | $ | 155,000 |
| Salary toowners | $ | (50,000) |
| Employee wages | $ | (10,000) |
| Depreciationexpense | $ | (5,000) |
| Miscellaneousexpenses | $ | (1,000) |
| Gain on sale ofmachinery | $ | 12,000 |
| Interest income | $ | 40,000 |
| Dividend income | $ | 65,000 |
| ⢠| Assume that if Omniocular were a C corporation for 2015, itstaxable income would have been $88,500. |
| b. | How much LIFO recapture tax is Omniocular required to pay andwhen is it due? |
| c. | How much built-in gains tax, if any, is Omniocular required topay? |
| d. | How much excess net passiveincome tax, if any, is Omniocular required to pay? |
| e. | Assume Barry's basis in his Omniocular stock was $40,000 onJanuary 1, 2015. What is his stock basis on December 31, 2015? |
For the following questions, assume that after electing Scorporation status Barry and Winnie had a change of heart and filedan election to terminate Omniocularâs S election, effective August1, 2016. |
| ⢠| In 2016, Omniocular reported the following income/expenseitems: |
| January 1âJuly 31 2016 (213 days) | August 1âDecember 31, 2016 (153 days) | January 1âDecember 31, 2016 | ||||||
| Sales revenue | $ | 80,000 | $ | 185,000 | $ | 265,000 | ||
| Cost of goodssold | (40,000) | (20,000) | (60,000) | |||||
| Salaries to Barryand Winnie | (60,000) | (40,000) | (100,000) | |||||
| Depreciationexpense | (7,000) | (2,000) | (9,000) | |||||
| Miscellaneousexpenses | (4,000) | (3,000) | (7,000) | |||||
| Interest income | 6,000 | 5,250 | 11,250 | |||||
| Overall net income(loss) | $ | (25,000) | $ | 125,250 | $ | 100,250 | ||
| f. | For tax purposes, how would you recommend Barry and Winnieallocate income between the short S corporation year and the shortC corporation year if they would like to minimize double taxationof Omniocularâs income? | ||||
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| g. | Assume in part (f) that Omniocular allocates income between theshort S and C corporation years in a way that minimizes the doubletaxation of its income. If Barryâs stock basis in his Omniocularstock on January 1, 2016, is $50,000, what is his stock basis onDecember 31, 2016? |
| h. | When is the earliest tax year inwhich Omniocular can be taxed as an S corporation again? | ||||||
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