Comprehensive Problems
1. [LO 1] Several years ago, your client, Brooks Robinson, started an office cleaning service. His business was very successful, owing much to his legacy as the greatest defensive third baseman in major league history and his nickname, "The Human Vacuum Cleaner." Brooks operated his business as a sole proprietorship and used the cash-basis method of accounting. Brooks was advised by his attorney that it is too risky to operate his business as a sole proprietorship and that he should incorporate to limit his liability. Brooks has come to you for advice on the tax implications of incorporation. His balance sheet is presented below. Under the terms of the incorporation, Brooks would transfer the assets to the corporation in return for 100 percent of the company's common stock. The corporation would also assume the company's liabilities (payables and mortgage).
Balance Sheet
Assets Tax Basis FMV
Accounts receivable 0 5,000
Cleaning equipment (net) 25,000 20,000
Building 50,000 75,000
Land 25,000 50,000
Total assets $100,000 $150,000
Liabilities
Accounts payable 0 10,000 Salaries payable 0 5,000
Mortgage on land and building 35,000 35,000
Total liabilities $35,000 $50,000
a. How much gain or loss (on a per asset basis) does Brooks realize on the transfer of the assets to the corporation?
b. How much, if any, gain or loss (on a per asset basis) does he recognize?
c. How much gain or loss, if any, must the corporation recognize on the receipt of the assets of the sole proprietorship in exchange for the corporation’s stock?
d.What basis does Brooks have in the corporation’s stock?
e. What is the corporation’s tax basis in each asset it receives from Brooks?
f. How would you answer the question in B if Brooks had taken back a 10-year note worth $25,000 plus stock worth $75,000 plus the liability assumption?
g.Will Brooks be able to transfer the accounts receivable to the corporation and have the corporation recognize the income when the receivable is collected?
h. Brooks was depreciating the equipment (200% declining balance) and building (straight-line) using MACRS when it was held inside the proprietorship How will the corporation depreciate the equipment and building? Assume Brooks owned the equipment for four years (7 year property) and the building for 6 years.
i.Will the corporation be able to deduct the liabilities when paid? Will it matter which accounting method (cash versus accrual) the corporation uses?
j.Would you advise Brooks to transfer the land and building to the corporation? What other tax strategy might you suggest to Brooks with respect to the realty?
2. [LO 4] Your client, Midwest Products, Inc. (MPI), is a closely-held, calendar-year, accrual-basis corporation located in Fowlerville, Michigan. MPI has two operating divisions. One division manufactures lawn and garden furniture and decorative objects (furniture division), while the other division manufactures garden tools and hardware (tool division). MPI’s single class of voting common stock is owned as follows:
Shares Tax Basis FMV
Iris Green 300 $2,000,000 $3,000,000
Rose Ruby 100 1,200,000 1,000,000
Lily White 100 800,000 1,000,000
Totals 500 $4,000,000 $5,000,000
The three shareholders are unrelated.
Outdoor Living Company (OLC), a publicly-held, calendar-year corporation doing business in several midwestern states, has approached MPI about acquiring its furniture division. OLC has no interest in acquiring the tool division, however. OLC’s management has several strong business reasons for the acquisition, the most important of which is to expand the company’s market into Michigan. Iris, Rose, and Lily are amenable to the acquisition provided it can be accomplished in a tax-deferred manner.OLC has proposed the following transaction for acquiring MPI’s furniture division. On April 30, 2010, OLC will create a 100-percent owned subsidiary, OLC Acquisition, Inc (OLC-A). OLC will transfer to the subsidiary 60,000 shares of OLC voting common stock and $2,000,000. The current fair market value of the OLC voting stock is $50 per share ($3,000,000 in total). Each of the three MPI shareholders will receive a pro rata amount of OLC stock and cash.
As part of the agreement, MPI will sell the tool division before the acquisition, after which MPI will merge into OLC-A under Michigan and Ohio state laws (a forward triangular Type A merger). Pursuant to the merger agreement, OLC-A will acquire all of MPI’s assets, including 100 percent of the cash received from the sale of the tool division ($2,000,000), and will assume all of MPI’s liabilities. The cash from the sale of the tool division will be used to modernize and upgrade much of the furniture division’s production facilities. OLC’s management is convinced that the cash infusion, coupled with new management, will make MPI’s furniture business profitable. OLC management has no plans to liquidate OLC-A into OLC at any time subsequent to the merger. After the merger, OLC-A will be renamed Michigan Garden Furniture, Inc.
a.Determine whether the proposed transaction meets the requirements to qualify as a tax-deferred forward triangular Type A merger. Consult Rev. Rul. 88-48 and Rev. Rul. 2001-25 in thinking about the premerger sale of the tool division assets.
b.Could the proposed transaction qualify as a reverse triangular Type A merger if OLC-A merged into MPI? If not, how would the transaction have to be restructured to meet the requirements to be a reverse triangular merger?
3. [LO 5] Rex and Felix are the sole shareholders of the Dogs and Cats Corporation (DCC). After several years of operations, they decided to liquidate the corporation and operate the business as a partnership. Rex and Felix hired a lawyer to draw up the legal papers to dissolve the corporation, but they need some tax advice from you, their trusted accountant. They are hoping you will find a way for them to liquidate the corporation without incurring any corporate-level tax liability.
The DCC’s tax accounting balance sheet at the date of liquidation is as follows:
Assets Tax Basis FMV
Cash $30,000 $30,000
Accounts receivable 10,000 10,000
Inventory 10,000 20,000
Equipment 30,000 20,000
Building 15,000 30,000
Land 5,000 40,000
Total assets $100,000 $150,000
Liabilities
Accounts payable $5,000
Mortgage payable - Building 10,000
Mortgage payable - Land 10,000
Total liabilities $25,000
Shareholders’ Equity
Common stock - Rex (80%) $60,000 $100,000
Common stock - Felix (20%) 30,000 25,000
Total shareholders equity $90,000 $125,000
a Compute the gain or loss recognized by Rex, Felix, and DCC on a complete liquidation of the corporation assuming each shareholder receives a pro rata distribution of the corporation’s assets and assumes a pro rata amount of the liabilities.
b. Compute the gain or loss recognized by Rex, Felix, and DCC on a complete liquidation of the corporation assuming Felix receives $25,000 in cash and Rex receives the remainder of the assets and assumes all of the liabilities. Assume Felix received the accounts receivable and equipment and assumed the accounts payable.
c. Will Felix recognize any income when he collects the accounts receivable?
d.Will Felix be able to take a deduction when he pays the accounts payable?
Assume Rex is a corporate shareholder of DCC.
e Compute the gain or loss recognized by Rex, Felix, and DCC on a complete liquidation of the corporation assuming each shareholder receives a pro rata distribution of the corporation’s assets and assumes a pro rata amount of the liabilities.
f.Compute the gain or loss recognized by Rex, Felix, and DCC on a complete liquidation of the corporation assuming Felix receives $25,000 in cash and Rex receives the remainder of the assets and assumes all of the liabilities.
Assume the equipment was contributed by Rex to DCC in a §351 transaction two months prior to the liquidation. At the time of the contribution, the property’s fair market value was $25,000.
g.Would the tax result change if the property was contributed one year ago? Two years ago? Three years ago?