Case Studies in Taxation

Hawaiian Memories, Inc. (HMI) is a C corporation that was formed in 2007 in Maui. The company markets specialty tourism products of the islands of Hawaii. The initial incorporators were Angie Lee and Bob Lin, who now own 1,000 shares of voting common stock and 100 shares of preferred stock each. The company has eight employees who collectively own 500 shares of nonvoting stock. Most of the employees have worked for the company for several years. They purchased the stock when the company offered it at the end of each year. Two own 100 shares each; the other six own 50 shares each.

None of the shareholders are related to each other by blood or marriage, except for Angie and Bob. All individual shareholders are native Hawaiians except for Inge; she is Swedish and has lived on Maui and worked for HMI for three years. Inge plans to move back to Sweden in one year and try to develop markets for HMI products there.

Another stockholder is the Plantation Sugar Partnership (PSP). PSP owns 500 nonvoting common shares; it supplies raw sugar in bulk to HMI. Bob Lin and his sister Katie each own 50% of PSP.

The corporation uses a June 30 year end. The year was chosen arbitrarily. All of the HMI shareholders use calendar years. Financial statements for the year ended June 30, 2012 are attached. HMI does not expect that it will generate any significant increases in investment or passive activity income in the coming years.

This was the first year of corporate operating losses in some time. The corporation elected not to carry back the losses because the tax rate paid in those years was lower than they expect to pay in the future. Bob and Angie expect one or two more years of losses and then steady increases in net income.

Bob lives in Hawaii and manages operations there. Angie moved to San Francisco in 2008 to develop mainland markets for their products. Both earn annual salaries of $150,000. The shareholders and all employees are provided accident and health insurance. The company contributes 10% of each employee's salary to a defined contribution pension plan each year.

PART I

On October 1, 2012, Bob and Angie came to your office for the first time. They have just filed the corporate return for the fiscal year ended June 30, 2012 and are interested in having you take over all the future tax work for the corporation. They inform you that they have just read an article in Tourism Retailing about the tax and cash-flow benefits of pass-through losses. They have filed an election to be an S corporation, effective on July 1, 2012.

Bob and Angie signed the consent for the S election because they were the only shareholders with voting stock. Their reasoning for making the S election is that they expect losses for a year or two as they try to expand, and they would like to use the losses already incurred as well as the prospective losses against their other income.

Review all relevant information and identify any issues related to conversion to S status.