Advanced Business Taxation
Consider the following hypothetical:
Dawn Taylor is currently employed by the state Chamber of Commerce. While she enjoys the relatively short workweeks, she would like to work for herself rather than for an employer. In her current position, she deals with a lot of successful entrepreneurs who have become role models for her. Dawn has also developed an extensive list of contacts that should serve her well.
It has taken a while but Dawn believes she has finally developed a viable new business idea. Her idea is to design and manufacture cookware that remains cool to the touch when in use. She has had several friends try out her prototype cookware and they have consistently given the cookware rave reviews. With this encouragement, Dawn started giving serious thought to making "Cool Touch Cookware" (CTC).
Dawn has enough business background to realize that she is embarking on a risky path, but one, she hopes, with significant potential rewards down the road. After creating some initial income projections, Dawn realized that it will take a few years for the business to become profitable. After that, she hopes that the sky is the limit. She would like to grow her business and perhaps at some point "go public" or sell the business to a large retailer. This could be her ticket to thelifestyle of the rich and famous.
Dawn, who is single, has decided to quit her job with the state Chamber of Commerce so that she can focus all of her efforts on the new business. Dawn has some savings to support her for a while but she does not have any other source of income. Dawn was able to recruit Linda and Mike to join her as initial equity investors in CTC. Linda has an MBA and a law degree. She was employed as a business consultant when she decided to leave that job and work with Dawn and Mike. Linda's husband earns around $300,000 a year as an engineer (employee). Mike owns a very profitable used car business. Because buying and selling used cars takes all his time, he is interested in becoming only a passive investor in CTC. He wants to get in on the ground floor because he really likes the product and believes CTC will be wildly successful. While CTC originally has three investors, Dawn and Linda have plans to grow the business and seek more owners and capital in the future.
The three owners agree that Dawn will contribute land and cash for a 30 percent interest in CTC, Linda will contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Mike will contribute cash for a 40 percent interest. The plan calls for Dawn and Linda to be actively involved in managing the business while Mike will not be. The three equity owners' contributions are summarized as follows:
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Dawn Contributes
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FMV
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Adjusted Basis
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Ownership Interest
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Land (held as investment)
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$120,000
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$70,000
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30%
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Cash
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$ 30,000
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|
|
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Linda Contributes
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Services
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$150,000
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30%
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Mike Contributes
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|
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Cash
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$200,000
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40%
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Working together, Dawn and Linda made the following five-year income and loss projections for CTC. They anticipate the business will be profitable and that it will continue to grow after the first five years.
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Cool Touch Cookware
5-Year Income and Loss Projections
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Year
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Income (Loss)
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1
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$(200,000)
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2
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(80,000)
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3
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(20,000)
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4
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60,000
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5
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180,000
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To get the business activities started, Dawn and Linda determined that CTC will need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices. Also, in need of additional cash, Dawn and Lindaarranged to have CTC borrow $300,000 from a local bank and to borrow $200,000 cash from Mike. CTC will pay Mike a market rate of interest on the loan but there will be no fixed date for principal repayment.
Required: Dawn wants to know what type of tax entity they should choose for CTC. She has come to you in order to obtain a full understanding of those alternative optionsincluding a basic understanding of both the tax and nontax aspects of each option. Write a professional memorandum fully explaining those options. You must also provide Dawn with your professional recommendation as to which type of entity she should choose and clearly support your recommendation.