The situation in this case study revolves around Sally, a member of the Board of Sally Susie's Donut Shop, Inc. (SSDS). SSDS uses an accrual method of accounting and over the past three years has seen volatile sales. Sally is unhappy with her previous tax advisor and wants new advice. Our task is to outline a preliminary interview with Sally to ensure that we ask the right questions.
For tax purposes, it is important to forecast cash flow and income. Sally, in Y1 you posted taxable income of $250k, in Y2 $10k, and in Y3 $150K. Were these numbers based on actual gross sales, or did your deductions and depreciation change drastically between Y1 and Y2?
Was the $50k contribution to a 501(c) charity actually donated, or promised? Was this done with the approval of the Board of Directors?
Based on income, was there a particular reason for donating what was about 20% of the annual taxable income? To reduce tax, personal reasons, particular charity?
(Notes: If SSD did make over this money, they would have to show all relevant canceled checks, acknowledgment letters from the charity, and appraisals for donated property. The Pension Protection Act specifies that the organization keeps written records of all cash donations. This must indicate the name of the charitable organization, the date of contribution, and the amount of contribution (Internal Revenue Service, 2006).
Was the $50k donated in a lump sum, and when? If the donation was made in increments, there should be a paper trail and proof in the form of cancelled checks and/or acknowledgements from the organization.
A 501 (c) organization has 28 different types of nonprofit organizations that are exempt from some federal taxes. A 501(c) 3 is a classified as a religious, educational, charitable, scientific, literary, safety, sports or prevention of cruelty to animals' organization. Which organization received the donation? Are there meeting notes that explain this amount?
Was the $50k in case or the value of goods? If goods and the donations are above $500, there must be documentation and an appraisal based on fair market value. In addition, IRS rules note that: "For any contribution of $250 or more (including contributions of cash or property), you must obtain and keep in your records a contemporaneous written acknowledgment from the qualified organization indicating the amount of the cash and a description of any property contributed. The acknowledgment must say whether the organization provided any goods or services in exchange for the gift and, if so, must provide a description and a good faith estimate of the value of those goods or service (Internal Revenue Service, 2013).
Depending on the answers to the above questions, for tax planning purposes, the law (§ 170(a) (1)) is that the organization / donor can deduct cash contributions in full up to 50% of their adjusted gross income. Since the organization contributed $50k that year and made only $10K they also have the option of having the excess carried over to the following tax year or more up to a maximum of five years. However, the law also states that the board of directors must have authorized the contribution and the election for the return or carryover must be made at the time of filing the tax return (Cornell University Law School, 2013).
Question 2: This scenario involves a Shareholder who transfers $100k FMV property with a $50AB to Corporation X in exchange for stock worth $100k. A owned 90% of the stock prior to the transfer.
Shareholder A is actually in a better position than Corporation X for the following reason: The property was accepted, and according to Section 1001(c), he,(A) as taxpayer, must recognize and accept all gain or loss realized on the sale or exchange of this property, "except as otherwise provided." Shareholder A, however, is receiving the stock and according to Section 351(a) "no gain or loss shall be recognized if property is transferred to a controlled corporation "solely" in exchange for its stock." (If the transferor receives not only stock (non-recognition property) but also money or other property ("boot") in the exchange, § 351(b) comes into play and requires that gain (but not loss) must be recognized to the extent of the fair market value of the boot, but not in excess of the amount of the transferor's realized gain under § 1001) (Cornell University Law School, 2013).
One key to this statute is that "no loss to such recipients shall be recognized." Thus, we also have Section 351 which maintains that no gain or loss shall be recognized if property is exchanged solely for stock of a controlled corporation. Except for $10k of the stock, A is a controlled corporation. Regarding Shareholder A and Corporation X, if it were entirely controlled by A, Section 351 holds that the shareholder holds the other corporation's stock with a zero basis. Excluding the $10k. The $10k will likely be taxed based on the circumstances of the transaction and the relevant "special rules where distribution to shareholders" occurs (Cornell University Law School, 2013).
Question 3: Captain Hook wishes to go into business with the Mad Hatter in a company called "Pirate Gone Mad." This will be a manufacturing company that specializes in unique hats. Each will invest $100k into the company and need a fairly quick return on investment. The issue surrounds the legal issues of investing.
The enterprise will be a shared partnership with each investing the same amount of money. The owners intend to finance the business through tiered levels of financing.
There are four main business entity choices: sole proprietorship, partnership, limited liability company (LLC) and corporation. Each has its advantages and disadvantages. If they elect a LLC, the organization will be a hybrid of a corporation and a partnership. The basic idea is that it is more of a flexible instrument and offers its owners less risk than a partnership or sole proprietorship. It does, however, have pass-through tax implications meaning that all profits and losses flow through to the owners. LLC's are treated as entities, which also protects the owner from other forms of liability. The LLC can be sold, assigned, and while it has economic benefit, can have investments, and act separate legally from owners. Some states, however, impose special penalties on LLCs. LLC's are, as well, considered riskier than corporations for credit-granting, and often require personal guarantees (Shenkman, 2003).
Because the owners wish the organization to grow quickly and spread through tiered levels of financing, there are two types of corporation structures that they may wish to investigate: subchapter C and subchapter S. Subchapter C is the corporation that this partnership has in mind where there are multiple investors. With C, both partners will receive multiple flows of finance but they will also accrue double taxation. At least at the beginning of the entity, the best form of business entity may be a LLC. Mad Hatter and Capt. Hook will follow the rules of a partnership whilst also adopting laws of a small corporation.
The laws running a Partnership are defined by the Uniform Partnership Act which states that both partners equally share responsibility and profit as well as loss of business.
Both partners sign a partnership agreement which is a formal, legally binding document that outlines their rights, responsibilities and financial involvement in the partnership.
Each of the company's partners shares the same tax liability for profits from the business. At the same time, if the business makes a profit, both partners share equally in those profits (Riley Associates, PC, 2010).
Captain Hook and Mad Hatter can also incorporate rules in their Agreement for how they want the shared business to work. For example, the agreement can indicate that Hook is responsible for handling financial accounting and management of…