COMPREHENSIVE PROBLEMS

83. {Planning} Dawn Taylor is currently employed by the state Chamber of Commerce. While she en oys the relati!ely short wor"wee"s# she e!entually would li"e to wor" for herself rather than for an employer. $n her current position# she deals with a lot of successful entrepreneurs who ha!e become role models for her. Dawn has also de!eloped an e%tensi!e list of contacts that should ser!e her well when she starts her own business. $t has ta"en a while but Dawn belie!es she has finally de!eloped a !iable new business idea. &er idea is to design and manufacture bed sheets that ha!e !arious colored patterns and are made of uni'ue fabric blends. The sheets loo" great and are e%tremely comfortable whether the bedroom is warm or cool. (he has had se!eral friends try out her prototype sheets and they ha!e consistently gi!en the sheets ra!e re!iews. With this encouragement# Dawn started gi!ing serious thoughts to ma"ing )Color Comfort (heets* a moneyma"ing enterprise. Dawn had enough business bac"ground to reali+e that she is embar"ing on a ris"y path# but one# she hopes# with significant potential rewards down the road. ,fter creating some initial income pro ections# Dawn reali+ed that it will ta"e a few years for the business to become profitable. ,fter that# she hopes the s"y-s the limit. (he would li"e to grow her business and perhaps at some point )go public* or sell the business to a large retailer. This could be her tic"et to the rich and famous. Dawn# who is single# decided to 'uit her ob with the state Chamber of Commerce so that she could focus all of her efforts on the new business. Dawn had some sa!ings to support her for a while but she did not ha!e any other source of income. Dawn was able to recruit .inda and /i"e to oin her as initial e'uity in!estors in CC(. .inda has an /0, and a law degree. (he was employed as a business consultant when she decided to lea!e that ob and wor" with Dawn and /i"e. .inda-s husband earns around 1322#222 a year as an engineer 3employee4. /i"e owns a very profitable used car business. 0ecause buying and selling used cars ta"es all his time# he is interested in becoming only a passi!e in!estor in CC(. &e wanted to get in on the ground floor because he really li"es the product and belie!es CC( will be wildly successful. While CC( originally has three in!estors# Dawn and .inda ha!e plans to grow the business and see" more owners and capital in the future. The three owners agreed that Dawn would contribute land and cash for a 32 percent interest in CC(# .inda would contribute ser!ices 3legal and business ad!isory4 for the first two years for a 32 percent interest# and /i"e would contribute cash for a 52 percent interest. The plan called for Dawn and .inda to

be acti!ely in!ol!ed in managing the business while /i"e would not be. The three e'uity owners- contributions are summari+ed as follows6

Adjusted Dawn Contributed .and 3held as in!estment4 Cash FMV 1782#222 132#222 Basis

Ownershi Interest

192#222

32:

Linda Contributed (er!ices 17;2#222 32:

Mi!e Contributed Cash 1822#222 52:

Wor"ing together# Dawn and .inda made the following fi!e<year income and loss pro ections for CC(. They anticipate the business will be profitable and that it will continue to grow after the first fi!e years.

Co"or Co#$ort Sheets %&'ear In(o#e and Loss Proje(tions

In(o#e 'ear 7 8 3 5 )Loss* 31822#2224 3182#2224 3182#2224 1=2#222

1782#222

With plans for Dawn and .inda to spend a considerable amount of their time wor"ing for and managing CC(# the owners would li"e to de!elop a compensation plan that wor"s for all parties. Down the road# they plan to ha!e two business locations 3in different cities4. Dawn would ta"e responsibility for the acti!ities of one location and .inda would ta"e responsibility for the other. >inally# they would li"e to arrange for some performance<based financial incenti!es for each location. To get the business acti!ities started# Dawn and .inda determined CC( would need to borrow 1822#222 to purchase a building to house its manufacturing facilities and its administrati!e offices 3at least for now4. ,lso in need of additional cash# Dawn and .inda arranged to ha!e CC( borrow 1322#222 from a local ban" and to borrow 1822#222 cash from /i"e. CC( would pay /i"e a mar"et rate of interest on the loan but there was no fi%ed date for principal repayment.

Re+uired,

,. $dentify significant ta% and nonta% issues or concerns that may differ across entity types.

0. Pro!ide your recommendation for forming CC( as a C corporation# ( corporation# ..C# or partnership. ?%plain your reasoning for your choice of entity# identify any issues that you may still be concerned about# and suggest recommendations for dealing with the concerns. Answer, a- Se.era" issues or (on(erns e/ist in $or#in0 a new business and (hoosin0 and entit1- So#e o$ the non&ta/ issues are, 2he ti#e and (ost to or0ani3e the entit1- Cor orations )both ta/ab"e and S (or orations* 0enera""1 are #ore (u#berso#e to $or#- 4enera" artnershi s tend to be a#on0 the easier entities to $or#-

Cor orations and LLCs ro.ide better "iabi"it1 rote(tion $or their owners than do 0enera" artnershi s- In this (ase5 Dawn is (on(erned about the ris!iness o$ the business and #a1 we"" want to (onsider this $a(torDawn5 Linda and Mi!e see# (on(erned about $"e/ibi"it1 in the business stru(ture- 2hat is5 the1 want to be ab"e to ro.ide Dawn and Linda er$or#an(e&based (o# ensation based on how their business "o(ations er$or#- 21 i(a""15 these issues $a.or entit1 $or#ation as a artnershi Fina""15 Dawn is "annin0 $or the $uture with an initia" ub"i( o$$erin0- IPOs are #ost easi"1 a((o# "ished with a ta/ab"e (or oration6 a"thou0h artnershi s and LLCs (an be $air"1 easi"1 (on.erted to ta/ab"e (or orations to a((o# "ish an IPO-

So#e o$ the ta/ issues or (on(erns in("ude, Based on the 0i.en ownershi er(enta0es5 the s(enario $ai"s the 78& er(ent (ontro" test sin(e Linda (ontributes on"1 ser.i(es2hus5 it is a ta/ab"e transa(tion i$ a C or S (or oration is $or#edDawn5 Linda5 and Mi!e wou"d "i!e to be ab"e to uti"i3e an1 "osses to redu(e their indi.idua" ta/ "iabi"ities in the ear"1 1ears o$ the business- F"ow&throu0h entities ro.ide the #ost $a.orab"e or0ani3ationa" $or# $or this ur ose- More s e(i$i(a""15 LLCs and artnershi s a""ow owners to bene$it b1 in(reasin0 their ta/ basis b1 the business debt so that the1 #a1 be ab"e to dedu(t "ar0er "osses than (an S (or oration shareho"ders- On(e the business be(o#es ro$itab"e in 1ear 95 usin0 an LLC5 artnershi or S (or oration $or# e"i#inates the doub"e& ta/ rob"e# o$ the ta/ab"e (or oration $or#I$ the owners want the $"e/ibi"it1 o$ s e(ia" a""o(ations to reward the owners5 entities ta/ed as artnershi s ro.ide the #ore $a.orab"e $or#2he owners #a1 be (on(erned about a1in0 the "owest ossib"e FICA and se"$&e# "o1#ent ta/es- In 0enera"5 ta/ab"e (or orations and S (or orations are $a.ored be(ause the e# "o1ee:shareho"der on"1 a1s ;-<% er(ent )=:>* o$ the FICA ta/ on an1 sa"ar1- In addition5 S&(or oration shareho"ders do not a1 se"$&e# "o1#ent ta/ on the in(o#e a""o(ated to the#- In (ontrast5 LLCs and artnershi owners #ust a1 se"$&e# "o1#ent ta/ on their in(o#e a""o(ations $ro# the business )i$ the1 are (onsidered 0enera" artners*I$ Dawn5 Linda5 and Mi!e wou"d "i!e to (onsider addin0 new owners to the business5 o eratin0 as a ta/ab"e (or oration or S (or oration #a1 be (ost"1 be(ause o$ the 78 er(ent (ontro" test a "i(ab"e to (ontributions to the business- In 0enera"5 (ontributions to LLCs and artnershi s are usua""1 ta/&$ree

re0ard"ess o$ whether it is the initia" (ontribution or a "ater addition o$ an ownerb- A$ter (onsiderin0 the abo.e5 Dawn5 Linda5 and Mi!e shou"d $or# CCS as an LLC3@. A.B 8C Dhang incorporated her sole proprietorship by transferring in!entory# a building# and land to the corporation in return for 722 percent of the corporation-s stoc". The property transferred to the corporation had the following fair mar"et !alues and ta%<ad usted bases.

>/E $n!entory 0uilding .and Total 1 82#222 7;2#222 832#222 1 522#222

Ta%<,d usted 0asis 1 72#222 722#222 322#222 1 572#222

The corporation also assumed a mortgage of 1722#222 attached to the building and land. The fair mar"et !alue of the corporation-s stoc" recei!ed in the e%change was 1322#222. The transaction met the re'uirements to be ta%<deferred under F3;7.

a. What amount of gain or loss does Dhang realize on the transfer of the property to her corporationG Answer, ?han0 rea"i3es a net "oss o$ @=85888 on this trans$er5 (o# uted as $o""ows,

Fair #ar!et .a"ue o$ sto(! re(ei.ed B Mort0a0e assu#ed b1 (or oration A#ount rea"i3ed & Adjusted ta/ basis o$ the Loss rea"i3ed

@A885888 =885888 @9885888

ro ert1 trans$erred9=85888 @ )=85888*

Hote that the o!erall 3172#2224 reali+ed loss consists of a 172#222 reali+ed gain on the in!entory# a 1;2#222 reali+ed gain on the building# and a 3192#2224 reali+ed loss on the land# computed as follows6

,mount Ieali+ed Ieali+ed $n!entory 82#222 0uilding ;2#222 .and 392#2224 Total 1372#2224 1 82#222 7;2#222 832#222 1 522#222

Ta%<,d usted 0asis Jain 3.oss4 1 72#222 722#222 322#222 1 572#222 1

b. What amount of gain or loss does Dhang recognize on the transfer of the property to her corporationG

Answer, ?han0 does not re(o0ni3e an1 0ain:"oss on the trans$er be(ause the re+uire#ents o$ CA%= are #et-

c.

What is Dhang-s ta% basis in the stoc" she recei!es in the e%changeG

Answer, @A=85888- ?han0Ds ta/ basis in the sto(! re(ei.ed is a substituted basis o$ the assets trans$erred "ess the #ort0a0e assu#ed b1 the (or oration )@9=85888 E =885888*-

d. What is the corporation-s ta%<ad usted basis in each of the assets recei!ed in the e%changeG

Answer,

2he (or oration re(ei.es a (arr1o.er basis in the assets re(ei.ed $ro# ?han05 redu(ed b1 the a00re0ate net bui"t&in "oss on the assets trans$erred5 whi(h is a""o(ated to the "and )the on"1 bui"t&in "oss asset*In.entor1 Bui"din0 Land )@A885888 E @=85888* 2ota" @ =85888 =885888 >F85888 @9885888

I$ the a00re0ate adjusted ta/ basis o$ ro ert1 trans$erred to a (or oration b1 a shareho"der in a CA%= trans$er e/(eeds the a00re0ate $air #ar!et .a"ue o$ the assets5 the a00re0ate ta/ basis o$ the assets in the hands o$ the trans$eree (or oration (annot e/(eed their a00re0ate $air #ar!et .a"ue- 2he a00re0ate redu(tion in ta/ basis is a""o(ated a#on0 the assets trans$erred in ro ortion to their res e(ti.e bui"t&in "osses i##ediate"1 be$ore the trans$er- As an a"ternati.e5 ?han0 and the (or oration (an e"e(t to redu(e her sto(! basis to $air #ar!et .a"ue )@A885888*- I$ this e"e(tion is #ade5 the (or oration wou"d ta!e a @A885888 basis in the "and-

,ssume the corporation assumed a mortgage of 1;22#222 attached to the building and land. ,ssume the fair mar"et !alue of the building is now 18;2#222 and the fair mar"et !alue of the land is 1;32#222. The fair mar"et !alue of the stoc" remains 1322#222.

e. &ow much# if any# gain or loss does Dhang recogni+e on the e%change assuming the re!ised factsG

Answer, E.en thou0h ?han0 did not re(ei.e an1 boot in the transa(tion be(ause the "iabi"it1 assu#ed b1 the (or oration e/(eeds the tota" ta/ adjusted basis o$ the ro ert1 ?han0 trans$erred to the (or oration b1 @F85888 )@%885888 & @9=85888*5 ?han0 #ust re(o0ni3e 0ain o$ @F85888 on the trans$er-

f. What is Dhang-s ta% basis in the stoc" she recei!es in the e%changeG

Answer, 2a/ adjusted basis o$ ro ert1 (ontributed@9=85888 F85888 )%885888* @ 8

B 4ain re(o0ni3ed on the e/(han0e & Mort0a0e assu#ed b1 (or oration 2a/ basis o$ sto(! re(ei.ed

g. What is the corporation-s ta%<ad usted basis in each of the assets recei!ed in the e%changeG

Answer, 2he 0ain re(o0ni3ed #ust be a""o(ated to the ta/ basis o$ the assets re(ei.ed b1 the (or oration in ro ortion to the assetsD re"ati.e $air #ar!et .a"ues5 as $o""ows,

In.entor1 )@=85888 B G@>85888:@7885888 / @F85888H* =>5>%8 Bui"din0 )@=885888 B G@>%85888:@7885888 / @F85888H* =>75=>%

Land )@A885888 B G@%A85888:@7885888 / @F85888H*A%F5<>% 2ota" @%885888

The total ta% basis of the three assets e'uals their carryo!er basis 31572#2224 plus the gain recogni+ed by Dhang on the e%change.