Comprehensive Problem
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?