Overview Brooke owns a sole proprietorship and has been your client for several years. Her business customizes
Question:
Overview
Brooke owns a sole proprietorship and has been your client for several years. Her business customizes apparel for teams and corporate events around the Midwest, such as youth sports programs, business outings, 5-K fundraising "fun runs", and others. She has been exploring the idea of incorporating the business with a few of her colleagues. In a previous conversation with her, you discussed the basic requirements under §351 that would allow her to defer any gains or losses on her contributed property when transferring to a controlled corporation. Now that she has discussed this possibility with her colleagues, she has come to you with some additional questions.
Brooke & Colleagues Background
Brooke
Brooke has cash, inventory, equipment, and a delivery van currently used in her business which she plans to transfer to the new corporation. Details about these assets are included in the schedule below.
Clara
Clara owns a plot of land in the area that she is holding for investment purposes. It would work very well for the business, and Clara is interested in transferring this property in exchange for stock. Details about this plot of land are included in the schedule below.
Steve
Steve has been working for Brooke part time for the last three years while completing his bachelor's degree. Now that he has graduated, he is interested in working for the business full-time. If given the opportunity, Steve would be willing to provide his services worth $40,000 in exchange for stock in the new corporation rather than salary. (Steve is living with his parents so does not have any expenses related to rent/food/etc.)
Li
Li is Brooke's attorney. She offers to provide $20,000 in legal services to help organize the corporation such as drafting the corporate charter and bylaws. Rather than being paid in cash, Li will accept stock in the newly-formed corporation.
Matt
Matt owns his own business nearby. Matt heard about Brooke's potential plans and offered to contribute computer equipment and an additional delivery van to the business in exchange for stock. Matt purchased the delivery van a few years ago, but it is no longer needed for his business. Details about the computer and vehicle are included in the schedule below.
Summary Schedule of Assets
Asset | FMV | Cost | Accumulated Depreciation |
Brooke | |||
Cash | $20,000 | ||
Inventory | $80,000 | $75,000 | |
Equipment | $35,000 | $50,000 | $5,000 |
Delivery Van | $25,000 | $45,000 | $5,000 |
Clara | |||
Land | $140,000 | $120,000 | |
Steve | |||
Services | $40,000 | ||
Li | |||
Legal Services | $20,000 | ||
Matt | |||
Computers | $10,000 | $6,000 | $0 |
Delivery Van | $30,000 | $60,000 | $40,000 |
Stock Issued
In exchange for their respective assets, each shareholder will receive the following number of shares in the corporation, each worth $400.
Brooke | 400 shares |
Clara | 350 shares |
Steve | 100 shares |
Li | 50 shares |
Matt | 100 shares |
Brooke's Questions
- Based on the information listed above that Brooke gathered from her colleagues and her brief research about §351, she is uncertain whether this would be a §351-qualified transaction because some shareholders are providing services. (Note: Brooke already has a general understanding of §351 requirements so you can be concise here and very briefly explain whether and why the facts outlined above meet each of the requirements).
- If they pursue this transaction as outlined above, do any of the shareholders recognize gain or loss on the transaction? What is the character of any gains or losses, and what is each of the shareholder's basis in their stock?
- What is the corporation's basis in each of the contributed assets?
- Brooke is calculating projected taxable income under this plan. Can the newly-formed corporation claim a compensation expense deduction for Steve and Li's services, and if so, when does the corporation take the deduction?
Graduate Case #1, Part 2:
Required: Based on the additional information listed below, provide Brooke a brief follow-up memo answering her questions at the end of this document.
Brooke Meeting
You send your memo from Part #1 to Brooke and set up a meeting to discuss it. During the meeting, some additional relevant information comes up. Specifically, there are liabilities related to some of the assets above. Brooke is considering having the corporation assume the liabilities but is unsure whether the transfer would now trigger gain for her colleagues or how this affects their basis in the stock. For this discussion, ignore the fact that having the corporation assume liabilities for some shareholders and not others would change the relative shares of stock issued to each shareholder. In other words, assume they still receive the same number of shares listed in the "Stock Issued" section in Part 1.
Clara's Liability
Clara's land is subject to a liability of $160,000. During a brief uptick in the value of real estate in the area, Clara's land went up in value and she refinanced the land using the higher value. It has since decreased in value slightly, making the value of the land slightly less than the liability.
Matt's Liabilities
Matt's vehicle is subject to a vehicle loan of $10,000. He used the loan to purchase the vehicles for business use. In addition, he took out a small $500 loan using his computers as collateral to buy his fiancé a nice birthday gift.
In your follow-up memo, be sure to answer these questions clearly and concisely:
- Does the assumption of these liabilities by the corporation affect Clara or Matt's basis in their stock? If so, how?
- Do Matt or Clara recognize gain if the corporation assumes these liabilities?
Taxation Of Individuals And Business Entities 2016
ISBN: 9781259334870
7th Edition
Authors: Brian Spilker, Benjamin Ayers, John Robinson, Edmund Outslay, Ronald Worsham, John Barrick, Connie Weaver