Case Scenario:
Dawn Taylor is currently employed by the state Chamber of Commerce. While she enjoys the relatively short workweeks, she eventually 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 when she starts her own business.
It has taken a while but Dawn believes she has finally developed a viable new business idea. Her idea is to design and manufacture bed sheets that have various colored patterns and are made of unique fabric blends. The sheets look great and are extremely comfortable whether the bedroom is warm or cool. She has had several friends try out her prototype sheets and they have consistently given the sheets rave reviews. With this encouragement, Dawn started giving serious thoughts to making "Color Comfort Sheets" a moneymaking enterprise.
Dawn had 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 the sky's 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 the rich and famous.
Dawn, who is single, decided to quit her job with the state Chamber of Commerce so that she could focus all of her efforts on the new business. Dawn had some savings to support her for a while but she did not have any other source of income. Dawn was able to recruit Linda and Mike to join her as initial equity investors in CCS. 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 CCS. He wanted to get in on the ground floor because he really likes the product and believes CCS will be wildly successful. While CCS 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 agreed that Dawn would contribute land and cash for a 30 percent interest in CCS, Linda would contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Mike would contribute cash for a 40 percent interest. The plan called for Dawn and Linda to be actively involved in managing the business while Mike would not be. The three equity owners' contributions are summarized as follows:
Dawn Contributed FMV Adjusted Basis Ownership Interest
Land (held as investment) $120,000 $70,000 30%
Cash $ 30,000
Linda Contributed
Services $150,000 30%
Mike Contributed
Cash $200,000 40%
Working together, Dawn and Linda made the following five-year income and loss projections for CCS. They anticipate the business will be profitable and that it will continue to grow after the first five years.
Color Comfort Sheets 5-Year Income and Loss Projections
Year Income (Loss)
1 ($200,000)
2 ($80,000)
3 ($20,000)
4 $60,000
5 $180,000
With plans for Dawn and Linda to spend a considerable amount of their time working for and managing CCS, the owners would like to develop a compensation plan that works for all parties. Down the road, they plan to have two business locations (in different cities). Dawn would take responsibility for the activities of one location and Linda would take responsibility for the other. Finally, they would like to arrange for some performance-based financial incentives for each location.
To get the business activities started, Dawn and Linda determined CCS would need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices (at least for now). Also, in need of additional cash, Dawn and Linda arranged to have CCS borrow $300,000 from a local bank and to borrow $200,000 cash from Mike. CCS would pay Mike a market rate of interest on the loan but there was no fixed date for principal repayment.
Required:
Problem 1. Identify significant tax and nontax issues or concerns that may differ across entity types.
Problem 2. Provide your recommendation for forming CCS as a C corporation, S corporation, LLC, or partnership. Explain your reasoning for your choice of entity, identify any issues that you may still be concerned about, and suggest recommendations for dealing with the concerns.