Taxation for Decision Makers, 2012 Edition

Shirley Dennis-Escoffier, Karen A. Fortin

ISBN: 978-1-118-09155-5

ACTG542 Chapter 10 Sole Proprietorship and Flow-Throw Entities Problem Assignments Questions

61. Choice of Entity

Cynthia needs your advice regarding which form of business entity to choose for her new business. She expects the new business will have losses of approximately $80,000 in each of the first two years but anticipates profits that will grow steadily thereafter. Cynthia has no cash to contribute to the business but plans to work 50 or more hours per week managing the day-to-day operations of the new business. Four individuals will contribute $50,000 each to start the business. To fund growth, Cynthia anticipates that additional funding will be needed in three years. Cynthia wants to meet with you next week to discuss your analysis and preliminary recommendations.

a. Based on this information only, what would you recommend?

b. Before meeting with Cynthia, prepare a list of questions you would like to ask to obtain the additional information you would need to make a more thorough analysis.

62. S Corporation Losses

Prior to BJ Corporation’s year-end, its sole shareholder comes to you for advice. BJ is an established S corporation that was profitable until two years ago when the economy faltered. Due to distributions and losses passed through in prior years, the shareholder’s basis in the S corporation is only $10,000. He anticipates that the corporation will have a loss of $50,000 in the current year. His previous accountant, who retired this year, had mentioned something to him about losses not being deductible if he did not have stock basis. What are the shareholder’s alternatives? Make a list of questions you would ask the shareholder to assist you in selecting between alternatives.

Solution: To deduct the losses in excess of his $10,000 basis currently, the shareholder has several options: he can make an additional investment in the capital of the corporation or he can lend the corporation sufficient money to establish debt basis against which to deduct the losses. His last option is to do nothing and leave the losses suspended until he again has basis against which to deduct them through income generated by the corporation.

63. Choice of Entity

Clare and Cora have been making wedding cakes in their homes for several years. The Health Department just learned about this and now requires them to shut down or find a commercial kitchen that can be subject to the proper inspections. Clare and Cora located a suitable small restaurant they can rent for $1,000 per month or purchase for $100,000. Their monthly payments would be $1,000 per month for interest and taxes and $100 per month for the principal on a commercial mortgage if they put $10,000 down. Clara and Cora each have $10,000 in savings they can put into the business. Their husbands are also employed and would be able to provide some support during the start-up period. Both families are in the 28 percent marginal tax bracket. The women know that the first several years will be difficult, as they will need to build the business by more than word of mouth. As a result, their business plan shows losses of $5,000 in the first year, $4,000 in the second year, and $2,000 in the third year, but the fourth year and beyond show profits. These losses do not include either the rent or the mortgage payment. How do you suggest they set up their business? Should they buy or rent the building?

Taxation for Decision Makers, 2012 Edition

Shirley Dennis-Escoffier, Karen A. Fortin

ISBN: 978-1-118-09155-5

ACTG542 Chapter 10 Sole Proprietorship and Flow-Throw Entities Problem Assignments Questions

61. Choice of Entity

Cynthia needs your advice regarding which form of business entity to choose for her new business. She expects the new business will have losses of approximately $80,000 in each of the first two years but anticipates profits that will grow steadily thereafter. Cynthia has no cash to contribute to the business but plans to work 50 or more hours per week managing the day-to-day operations of the new business. Four individuals will contribute $50,000 each to start the business. To fund growth, Cynthia anticipates that additional funding will be needed in three years. Cynthia wants to meet with you next week to discuss your analysis and preliminary recommendations.

a. Based on this information only, what would you recommend?

b. Before meeting with Cynthia, prepare a list of questions you would like to ask to obtain the additional information you would need to make a more thorough analysis.

62. S Corporation Losses

Prior to BJ Corporation’s year-end, its sole shareholder comes to you for advice. BJ is an established S corporation that was profitable until two years ago when the economy faltered. Due to distributions and losses passed through in prior years, the shareholder’s basis in the S corporation is only $10,000. He anticipates that the corporation will have a loss of $50,000 in the current year. His previous accountant, who retired this year, had mentioned something to him about losses not being deductible if he did not have stock basis. What are the shareholder’s alternatives? Make a list of questions you would ask the shareholder to assist you in selecting between alternatives.

Solution: To deduct the losses in excess of his $10,000 basis currently, the shareholder has several options: he can make an additional investment in the capital of the corporation or he can lend the corporation sufficient money to establish debt basis against which to deduct the losses. His last option is to do nothing and leave the losses suspended until he again has basis against which to deduct them through income generated by the corporation.

63. Choice of Entity

Clare and Cora have been making wedding cakes in their homes for several years. The Health Department just learned about this and now requires them to shut down or find a commercial kitchen that can be subject to the proper inspections. Clare and Cora located a suitable small restaurant they can rent for $1,000 per month or purchase for $100,000. Their monthly payments would be $1,000 per month for interest and taxes and $100 per month for the principal on a commercial mortgage if they put $10,000 down. Clara and Cora each have $10,000 in savings they can put into the business. Their husbands are also employed and would be able to provide some support during the start-up period. Both families are in the 28 percent marginal tax bracket. The women know that the first several years will be difficult, as they will need to build the business by more than word of mouth. As a result, their business plan shows losses of $5,000 in the first year, $4,000 in the second year, and $2,000 in the third year, but the fourth year and beyond show profits. These losses do not include either the rent or the mortgage payment. How do you suggest they set up their business? Should they buy or rent the building?