Tax Case Study

Tax Case Study Requirement Tax code section 721 "provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership." Both parties agreed to contribute personal assets to the partnership, and they, nor the LLC, suffers any tax consequences as a result of the conversion of the property to the partnership.

Because both contributed equal property to the LLC when it was formed (or so they thought) they both have a 50% ownership of the partnership. The initial basis of both is not actually 50%.

Tax code section 722 "provides that the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of the money and the adjusted basis of the property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under § 721(b) to the contributing partner at such time." This initial basis is figured only according to the money he contributed ($200,000). The value of the land Erik contributed was $250,000.

Thus, the value of the partnership according to this data is $450,000. However, also according to tax code section 722, Erik's land appreciated by $30,000 (this is added to his stake in the partnership) and Clark contributed $50,0000 in equipment (after depreciation and amount owed on the equipment were taken into account. Thus, the basis of LLC in the land and equipment it received is $330,000. Requirement 2 According to tax code section 704 the tax consequences from the gain of the fair market value (FMV) of the property is the responsibility of the contributing partner.

Thus, since Erik contributed the property to the LLC, he is responsible for the increased tax as a result of the higher sale value. This provision is made to make sure that the tax distribution is fair to all parties concerned. If the property had been sold for $240,000 instead of the actual $280,000 the responsibility of that basis would be the same.

Because Erik contributed the $250,000 he gains from the lower tax of a lower sale than the FMV, just as he would be responsible for the increased tax of a sale higher than the FMV. Requirement 3 Tax code section 167 says that "There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) (1) of property used in the trade or business, or (2) of property held for the production of income.

This means that the firm is allowed to take a deduction on the equipment and it further says that the tax can be calculated using the traditional method (section 167(g)). The traditional method that is referenced in this requirement is called straight-line depreciation. In this method, the company knows how much the asset is worth now and how much they will be able to sell the item for in a certain number of years.

The equipment was contributed by Clark, but since it was added to the partnership (part of his buy-in) it becomes part of the partnership and both partners receive benefit of the depreciation. This is handled under tax code section 1250 because of the accelerated depreciation taken in the $100,000 of the top. This section of the tax code says that this should be treated as ordinary income instead of capital gains. The total is $114,290 and the life is 7 years.

All the traditional method requires is that the total of the depreciated amount be divided by the number of years it will be viable to the company. Thus, $16,327 per year would be expensed. Because the two, Clark and Erik, are equal partners, they would share equally in all of the profits and losses of the company assets.

Of course, this does not include such things as added tax liability from the sale of property which is sold for more than the fair market value, but it does include depreciation of the equipment that is a part of the partnership agreement. Requirement 4 Separately stated items are not a part of the partnership.

According to tax code section 702 these are "(1) gains and losses from sales or exchanges of capital assets held for not more than 1 year; (2) gains and losses from sales or exchanges of capital assets held for more than 1 year; (3) gains and losses from sales or exchanges of property described in section 1231 (relating to certain property used in a trade or business and involuntary conversions); (4) charitable contributions (as defined in section 170(c)); (5) dividends with respect to which section 1(h)(11) or part VIII of subchapter B applies; (6) taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States; (7) other items of income, gain, loss, deduction, or credit, to the extent provided by regulations prescribed by the Secretary; and (8) taxable income or loss, exclusive of items requiring separate computation under other paragraphs of this subsection." Looking at the list, the ones that apply to Clark and Erik would be (1) because of the land that sold for more than it was originally appraised for, and any of the others that apply to business of a private nature that is not a part of the partnership.

According to the tax code the three loss limitations are that "Under IRC section 704(d), (1) the loss must not exceed the amount of the partner's basis in the partnership interest; (2) the loss is the subject of the at-risk rules of the IRC section 465; (3) the loss is subject to the passive activity rules or IRC section 469." These rules are set in place for fairness sake. One partner cannot stick the other partner with a greater tax liability that has nothing to do with the partnership.

These limitations were set in place for just such a partnership as Clark and Erik have. The answer to the last question is yes. The first loss limitation states that the loss cannot be greater than the initial outlay that the partner made for the partnership to exist. Both parties contributed $250,000 so the $125,000 is acceptable. However, as far as the fairness principle goes, the separately stated items will mean that the two may have to pay different taxes.

Basically, if the net capital gain is a certain amount that the partners will split, but one partner has a net capital gain or loss separate from that amount, then the two will have to pay different amounts. These two partners have a net capital loss of $250,000, so they split it and each has a net loss of $125,000 apiece which they have to declare. However, if Erik has a gain from another source of $30,000, his net loss would decrease to $95,000.

Thus, even though the two are in the business together, they do have lives outside of the LLC which are affected by gains and losses from their outside endeavors (which the capital gain Erik experienced from the sale of the property would be). This can all be found in section 702 (a) (1-6). Requirement 5 Tax code section 174 allows the partners options regarding deducting the research and design costs. The code says that the partners can use one of the following methods: expense treatment, capitalization/amortization, project by project, election or default.

The last two methods are not advised because the partnership would not be able to realize the tax savings immediately. This is a simple partnership and a relatively small operation. The expense treatment method only allows R & D. To be expensed one time, and the product that the partners are producing will require more research and development as technology improves. Thus, the first method is not advisable.

It is difficult to understand the project by project allowance, but since the partners have only one product, they may not want to incur the difficulty inherent in this one either. It also seems that the capitalization/amortization method can actually be the same as a project by project method. It seems that this company should use the capitalization/amortization method since they will not realize any gains from the R&D for a few years.

The second type of cost is incurred from getting ready to sell the product are covered in tax code section 195 under startup costs. This section of the tax code states "Section 195(a) provides that, except as otherwise provided in § 195, no deduction is allowed for start-up expenditures.

Section 195(b) provides that start-up expenditures may, at the election of the taxpayer, be treated as deferred expenses that are allowed as a deduction prorated equally over a period of not less than 60 months (beginning with the month in which the active trade or business begins).

Section 195(c)(1) defines "start-up expenditure," in part, as any amount (A) paid or incurred in connection with investigating the creation or acquisition of an active trade or business, and (B) which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred." Basically the partners can deduct expenses related to startup if they are connected to investigation of the market or if they were already operating a similar business.

Since there has been some cost associated with the startup investigation, the partners are able to deduct these expenses. They are also allowed to spread these expenses out over a 60-month period from the date of startup. The third method of deduction is found in the on-going expenses of the business.

Theses deductions, according to tax code section 162, have to be "ordinary and necessary expense that was paid or incurred during the taxable year in carrying on a trade or business activity." Thus any expense that was incurred that falls into this definition is acceptable to be deducted. If all of the deductions that the partners are able to claim basically make it to where one or both do not have to pay any tax, then they are subject to the alternative minimum tax.

This is in place because of a fairness doctrine established by the congress. It basically says that even though business expenses put a person under the threshold where they would normally have to pay taxes, they do have to pay at least some minimum amount. There are limits of income that the individual must meet before they would have to pay this amount, but both partners qualify.

The advice given would depend on the amount likely to be paid if all deductions were taken the first year or spread out over the 60-month period allowed. The goal is to find the method which would allow the partners to pay the least amount of tax. Requirement 6 According to section 179 businesses have three options depending on the type of deduction schedule they want, and the amount they have to deduct for the new equipment. The code has a "2011Deduction Limit - $500,000 (up from $250k previously).

Good on new and used equipment, including new software. 2011 Limit on equipment purchases - $2 Million Dollars (up from $800k previously). "Bonus" Depreciation - 100% (taken after the $500k deduction limit is reached). Note, bonus depreciation is only for new equipment. This can also be taken by businesses that exceed $2 million in capital equipment purchases." The government wants small businesses to flourish, especially since the economic outlook has been so unfavorable in recent years. Thus, they have increased the amount that can be deducted from equipment that was purchased for the business.

The tax code section 179 allows businesses to acquire new technology and equipment and deduct all or part of that equipment up to $500,000. As a matter of fact, the company can actually purchase more than the $500,000 in equipment and deduct the entire amount depending on the depreciation schedule the equipment is on. The additional equipment can be completely deducted from the businesses taxable property because it was purchased during the year and because it falls within the $500,000 that is allowed.

The loss that the company experienced decreases their amount of taxable income. That means that the amount they will be able to deduct is changed also. But, they have the option of taking the deduction over a number of years which means that they could eventually take the entire deduction. Requirement 7 CS: The actual question is will the $12 million be worth more to the company over the long-term or will the $18 million.

Since this is a discussion of what the tax liability would be, this discussion will not include loss of patent and subsequent amount that may give the company. For tax purposes, every year would be taxed as the income would be regarded as income from the company each of the six years or for the one year.

Of course, due to other factors, the tax rate may increase over the time of the contract and make it a wash as far as what is paid, but it would seem that CS should take the six payments based on the fact that it is guaranteed money and they would actually receive more over the life of the contract. Also, in the second scenario, CS loses the patent.

However, in the second scenario CS gains a great deal of immediate operating capital which would allow them to move on to other projects which may be even more profitable. Thus, it seems that they could benefit greatly from the second option. This could be a win-win for both firms. CDS: the second option seems the most attractive because they get the patent and they pay 33% less over the life of the contract. The tax rate is the same to them regardless also.

They would also have the patent to the product and the stated ability to make adjustments to the patent and to gain from that. There does not seem to be any advantage to the company in giving CS more money over the life of the contract, and also allowing CS to keep the patent. CDS would probably want to have as much control as possible. That means that they would probably elect the second option also.

There are gains for CS regardless the choice they make, but CDS seems to have a clear choice regarding the payments. However, the gain for CS could also be larger if they accept the second option, because they have an immediate influx of $10 million which will allow them to do more than they had previously hoped. Another plus for CS is that they have a good reputation around the country for producing innovative products.

If they stand still with the product they already have, other companies may be able to beat them to a new innovation. With the $10 million immediately they can fund more R&D. The second option seems like, as was said above, a win-win situation for both companies. Requirement 8 This is basically the same as the partners accepting a third party into their LLC partnership. If Emily accepts the 15% interest in the company, the other partners will now have a 42.5% stake respectively.

However, she could go with the 10/45/45 deal and $500,000 on top of that. The best deal for her is to take the 15% interest in the company rather than an immediate payment of $500,000 and a 10% stake. She will be immediately taxed on the $500,000 which is one problem. With the 15% she incurs no immediate tax liability. Of course, she is faced with the same company liability that the other partners are, but since this is basically a startup that would probably be deferred.

Also, she will make significantly more money by taking the 15% stake. The $500,000 may look good initially, but it will eventually be just a pittance. The technology is unique enough, and needed enough, that it will sell many units. She would benefit much more from the larger percentage in the long-term. The downside of the 15% ownership is that she could fail and receive almost nothing for her time investment.

This is mitigated by the fact that even if she does fail, she has still earned a competitive salary over the two years and can now receive new offers. The benefits in this case outweigh any problems. She is also not a part owner until the two years are up, so the initial tax issues will not fall to her.

Requirement 9 About an S corporation, the IRS web site says; " S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.

To qualify for S corporation status, the corporation must meet the following requirements: Be a domestic corporation; Have only allowable shareholders; including individuals, certain trust, and estates and may not include partnerships, corporations or non-resident alien shareholders; Have no more than 100 shareholders; Have one class of stock; Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.

As far as Clark and Erik are concerned, they meet all of the requirements because the are a domestic firm, have only two stockholders, and they meet the rest of the criteria as well. This means that they can apply for S corporation status, but the benefits of this type of move are very good for this situation. The main advantage of being an S corporation is that the partners are protected from creditors. There are several advantages that further separate it from a C corporation also.

The owners can take the losses of the business as deductions on their personal income tax reports, this type of business also allows the owners to save on business-related taxes from social security and Medicare, and the shareholders in an S corporation do not have to pay corporate income taxes.

Requirement 10 The agreements are used because the partners involved will want to make sure that they have first option to buy or sell the portion of the business owned by another partner if a partner dies or leaves for some other reason. Usually, this is in the case of death and both partners will purchase an insurance policy that is equal to the amount of the other partner's stake in the business.

Upon the death of one party, the other party will buy his or her shares, and give that money to his or her estate. This is called a cross-purchase. If the agreement is a cross-purchase, the tax liability to the surviving partner is based on the FMV of the shares minus the adjusted cost base. Thus, the surviving partner would be required to account for half of the amount for capital gains purposes.

The redemption buy-sell agreement is based on a stock purchase by the corporation of the deceased partner's shares. The reason this would be done instead of a cross-purchase is because it is easier to manage if there are multiple partners. In the case of Clark and Erik, it would be easier to just enter into a cross-purchase agreement. If Emily agrees to the 15% option and she and Erik marry, then they will own 57.5% of the company unless some other arrangements have been made.

This would complicate an arrangement unless Clark bought shares to get the partnership equal. If they are married and have are both owners equally. If no such agreement has been made, then at the death of one spouse, the other would own their shares. The only complication here as far as taxes concerning the company is that one partner would have more liability than the other. As far as tax liability incurred because of the marriage, the spouse would incur capital gains fees.

Requirement 11 A nexus is a connection and means that the company was incorporated in a certain state. Thus, the business and the company have a tax-related connection. Also, for tax purposes, apportionment regards how the tax is distributed by the state to its citizens. There are three factors that are considered: property, payroll and sales.

The general definitions of the three are: "(1) The property factor is the average value of the taxpayer's real and tangible personal property owned and/or rented and used during the taxable year divided by the average value of all of its real and tangible personal.