Smithon Widgets: Case Study
Memorandum
To: Mr. Jones,
From: Brian Banks
Date: 2/19/2014
Subject: Tax advice
In reference to the outright purchase of Smithon Widgets, I believe that this will result in an increase in your personal-tax liability. If you decide to buy this particular stock you will not only acquire all the assets that comes from obtaining this stock, but you will also acquire all of the liabilities of Smithon. In my professional opinion, issuing debt in Johnson Services Company to pay for the Smith Company would not be considered a favorable business move. In fact, I would not recommend this course of action for many reasons. One simple reason is that you would inherit Johnson Company’s existing operating loss issues. Most of Johnson Services’ assets are financed by debt, …show more content…
which would indicate that Johnson Company is already operating with an existing loss and is using its debt equity to obtain additional assets. The overall effect would turn away potential investors from you.
Purchasing the stock of Smithon outright, leaving it intact, would qualify as a Type B reorganization. Johnson Services would transfer some of their voting stock to the Smithon shareholders. Johnson Services would be required to have at least 80 percent of the total combined voting power and 80 percent of each class of nonvoting stock. (Rev. Rul. 59-259, 1959-2 CB 115). A disadvantage of C corporations is that they are subject to a form of double taxation. An income tax is imposed on the taxable income of the corporation, and no deduction is allowed for distributions to shareholders. When after-tax profits are distributed to shareholders as dividends, the shareholders generally must include the amounts in their taxable income. However, the tax rate applied to dividends received by shareholders is as follows: 0% for taxpayers in the 10 percent or 15 percent bracket and 15% for taxpayers in all other brackets. Partnerships, S corporations, and sole proprietorships are not subject to this because they are conduits. Their income passes through to the owners and is taxed at that level only (CCH Federal Taxation: Comprehensive Topics 2014 Edition Ch. 14).
Based on the above information I would definitely recommend that you convert Smithon from a C corporation to an S corporation and change the tax year in order to keep management and operations running smoothly.
Because C corporations are double taxed on dividends and profits, this conversion from a C corporation to an S corporation would deem very beneficial to you. However, I would never recommend this suggestion if Smithon Company was not subject to “built in” gains. Typically, the S corporation status would be more beneficial to corporations in their early stages. If the entity is being changed to an S corporation, the tax year would also change to comply with S corporation standards.
An S corporation is not a separate taxpaying entity. All income, expenses, gains, losses, etc. are passed through to the owner. In this case, Mr. Jones would be the owner. The income would be taxable at Mr. Jones’ personal tax rate. However, all income, expenses, gains, losses, etc. retain their identity when passed through to the shareholders. Therefore, Mr. Jones could offset personal income with net losses from Smithon. Additionally, Mr. Jones could use any capital losses against his personal capital
gains.
If you were to personally purchase the stock of Smithon and then convert the company to an S corporation he would end up being personally taxed on that company’s income. Changing to an S corporation would not be beneficial in this type of transaction because getting personally taxed on that company’s income would increase your personal tax liability.
Section 368 of the IRS Revenue Code identifies seven types of corporate reorganizations. As reported by Tax Almanac, the first recognized reorganization type is a statutory merger or acquisition. Mergers and consolidations are both based on the acquisition of a corporation 's assets by another company, according to the firm Greenstein, Rogoff, Olsen & Co., LLP.
I feel that type A: Merges and Consolidations would be beneficial to the financial situation of Johnson Services. This particular merger would increase profits and minimize losses in your current venture. This merger would increase market share and it would increase profitability also; something that Johnson services desperately need. Other types of possible organizations include: Type B: Acquisition --- Target Corporation Subsidiary; Type C: Acquisition-Target Corporation Liquidation; Type D: Transfer; Type E: Recapitalization; Type F: Identity Change; Type G: Transfer (http://smallbusiness.chron.com/7-types-corporate-reorganization-17885.html. Retrieved from http:// smallbusiness.chron.com/7-types-corporate-reorganization-17885.html).
A Type F reorganization consists of a “mere change in identity, form, or place of organization of one corporation, however effected.” Code Sec. 368(a)(1)(F). A Type F reorganization may also meet the definition of a Type A, C, or D reorganization as well, but it will still be treated as a Type F reorganization. Rev. Rul. 57-276, 1957-1 CB 126. Because the “old” corporation continues without change of ownership, the taxable year does not end (Code Sec. 381(b)), net operating losses may be carried back as well as forward (Code Sec. 381(b)), and neither Code Sec. 1244 nor S corporation status will be endangered. Reg. §1.1244(d)-3(d)(1); Rev. Rul. 64-250, 1964-2 CB 333. (CCH Federal Taxation: Comprehensive Topics 2014 Edition chapt.17).
You may also offset some of Johnson Services losses with the net operating loss carryover for up to the amount of taxable income for both corporations up to the day of the merger by a prorated amount of day. If there are additional losses, you may carry them over to the next year.
Considering that you do not have the cash available on hand to purchase Smithon company outright, I would recommend that you use Johnson’s stock to obtain Smithon company because your stock value would lower the price of purchasing Smithon.
On principal alone, a merger or acquisition would not affect your ability to change Smithon’s fiscal year end to a calendar year end. It would depend on Johnson Services’ fiscal year end and how they opted to file taxes. If Johnson’s fiscal year end is not calendar year end and they opted to file consolidated returns, you could not change Smithon’s fiscal year end to calendar year end. The fiscal year ends would need to be the same between Smithon and Johnson Services.
Based on my professional opinion a merger would be a great way for you to receive the ability to change the fiscal year end to a calendar year with the conversion of Smithon to an S corporation. However, the new entity may be imposed a built in gain tax to be sure that you are paying taxes on the liquidation of any assets belonging to Smithon prior to any changes in the entity. The S corporation could also be adding another loss to Johnson Services. Another factor would be the wages of Smithon’s shareholders. What are they worth? Are they reasonable? Would they be challenged by the IRS? Would it be worth it?
The use of a capital investment would indeed, affect your decision to use stock to buy Smithon. If you had the benefits of using capital investments you would not have to purchase Smithon using Johnson’s stock. Using Johnson’s stock to purchase Smithon company would deem less cost efficient than using capital investments.
Significant capital investment in Smithon could affect some of the previously provided information. The capital outlay would have to be clearly defined and outlined to determine the effect. The cost benefit would have to be evaluated to determine if an alternative reorganization Type would be more suitable.
Works Cited
1. CCH Federal Taxation: Comprehensive Topics 2014 Edition {Vital source bookshelf version}.
Retrived from http://devry.vitalsource.com/books/9780808033608/epubcfi/6/2
2. http://smallbusiness.chron.com/7-types-corporate-reorganization-17885.html. Retrieved from http:// smallbusiness.chron.com/7-types-corporate-reorganization-17885.html)
3. Http://www.irs.gov/pub/irs-wd/0213003.pdf. Web.
To: Mr. Jones,
From: Brian Banks
Date: 2/19/2014
Subject: Tax advice
In reference to the outright purchase of Smithon Widgets, I believe that this will result in an increase in your personal-tax liability. If you decide to buy this particular stock you will not only acquire all the assets that comes from obtaining this stock, but you will also acquire all of the liabilities of Smithon. In my professional opinion, issuing debt in Johnson Services Company to pay for the Smith Company would not be considered a favorable business move. In fact, I would not recommend this course of action for many reasons. One simple reason is that you would inherit Johnson Company’s existing operating loss issues. Most of Johnson Services’ assets are financed by debt, …show more content…
which would indicate that Johnson Company is already operating with an existing loss and is using its debt equity to obtain additional assets. The overall effect would turn away potential investors from you.
Purchasing the stock of Smithon outright, leaving it intact, would qualify as a Type B reorganization. Johnson Services would transfer some of their voting stock to the Smithon shareholders. Johnson Services would be required to have at least 80 percent of the total combined voting power and 80 percent of each class of nonvoting stock. (Rev. Rul. 59-259, 1959-2 CB 115). A disadvantage of C corporations is that they are subject to a form of double taxation. An income tax is imposed on the taxable income of the corporation, and no deduction is allowed for distributions to shareholders. When after-tax profits are distributed to shareholders as dividends, the shareholders generally must include the amounts in their taxable income. However, the tax rate applied to dividends received by shareholders is as follows: 0% for taxpayers in the 10 percent or 15 percent bracket and 15% for taxpayers in all other brackets. Partnerships, S corporations, and sole proprietorships are not subject to this because they are conduits. Their income passes through to the owners and is taxed at that level only (CCH Federal Taxation: Comprehensive Topics 2014 Edition Ch. 14).
Based on the above information I would definitely recommend that you convert Smithon from a C corporation to an S corporation and change the tax year in order to keep management and operations running smoothly.
Because C corporations are double taxed on dividends and profits, this conversion from a C corporation to an S corporation would deem very beneficial to you. However, I would never recommend this suggestion if Smithon Company was not subject to “built in” gains. Typically, the S corporation status would be more beneficial to corporations in their early stages. If the entity is being changed to an S corporation, the tax year would also change to comply with S corporation standards.
An S corporation is not a separate taxpaying entity. All income, expenses, gains, losses, etc. are passed through to the owner. In this case, Mr. Jones would be the owner. The income would be taxable at Mr. Jones’ personal tax rate. However, all income, expenses, gains, losses, etc. retain their identity when passed through to the shareholders. Therefore, Mr. Jones could offset personal income with net losses from Smithon. Additionally, Mr. Jones could use any capital losses against his personal capital
gains.
If you were to personally purchase the stock of Smithon and then convert the company to an S corporation he would end up being personally taxed on that company’s income. Changing to an S corporation would not be beneficial in this type of transaction because getting personally taxed on that company’s income would increase your personal tax liability.
Section 368 of the IRS Revenue Code identifies seven types of corporate reorganizations. As reported by Tax Almanac, the first recognized reorganization type is a statutory merger or acquisition. Mergers and consolidations are both based on the acquisition of a corporation 's assets by another company, according to the firm Greenstein, Rogoff, Olsen & Co., LLP.
I feel that type A: Merges and Consolidations would be beneficial to the financial situation of Johnson Services. This particular merger would increase profits and minimize losses in your current venture. This merger would increase market share and it would increase profitability also; something that Johnson services desperately need. Other types of possible organizations include: Type B: Acquisition --- Target Corporation Subsidiary; Type C: Acquisition-Target Corporation Liquidation; Type D: Transfer; Type E: Recapitalization; Type F: Identity Change; Type G: Transfer (http://smallbusiness.chron.com/7-types-corporate-reorganization-17885.html. Retrieved from http:// smallbusiness.chron.com/7-types-corporate-reorganization-17885.html).
A Type F reorganization consists of a “mere change in identity, form, or place of organization of one corporation, however effected.” Code Sec. 368(a)(1)(F). A Type F reorganization may also meet the definition of a Type A, C, or D reorganization as well, but it will still be treated as a Type F reorganization. Rev. Rul. 57-276, 1957-1 CB 126. Because the “old” corporation continues without change of ownership, the taxable year does not end (Code Sec. 381(b)), net operating losses may be carried back as well as forward (Code Sec. 381(b)), and neither Code Sec. 1244 nor S corporation status will be endangered. Reg. §1.1244(d)-3(d)(1); Rev. Rul. 64-250, 1964-2 CB 333. (CCH Federal Taxation: Comprehensive Topics 2014 Edition chapt.17).
You may also offset some of Johnson Services losses with the net operating loss carryover for up to the amount of taxable income for both corporations up to the day of the merger by a prorated amount of day. If there are additional losses, you may carry them over to the next year.
Considering that you do not have the cash available on hand to purchase Smithon company outright, I would recommend that you use Johnson’s stock to obtain Smithon company because your stock value would lower the price of purchasing Smithon.
On principal alone, a merger or acquisition would not affect your ability to change Smithon’s fiscal year end to a calendar year end. It would depend on Johnson Services’ fiscal year end and how they opted to file taxes. If Johnson’s fiscal year end is not calendar year end and they opted to file consolidated returns, you could not change Smithon’s fiscal year end to calendar year end. The fiscal year ends would need to be the same between Smithon and Johnson Services.
Based on my professional opinion a merger would be a great way for you to receive the ability to change the fiscal year end to a calendar year with the conversion of Smithon to an S corporation. However, the new entity may be imposed a built in gain tax to be sure that you are paying taxes on the liquidation of any assets belonging to Smithon prior to any changes in the entity. The S corporation could also be adding another loss to Johnson Services. Another factor would be the wages of Smithon’s shareholders. What are they worth? Are they reasonable? Would they be challenged by the IRS? Would it be worth it?
The use of a capital investment would indeed, affect your decision to use stock to buy Smithon. If you had the benefits of using capital investments you would not have to purchase Smithon using Johnson’s stock. Using Johnson’s stock to purchase Smithon company would deem less cost efficient than using capital investments.
Significant capital investment in Smithon could affect some of the previously provided information. The capital outlay would have to be clearly defined and outlined to determine the effect. The cost benefit would have to be evaluated to determine if an alternative reorganization Type would be more suitable.
Works Cited
1. CCH Federal Taxation: Comprehensive Topics 2014 Edition {Vital source bookshelf version}.
Retrived from http://devry.vitalsource.com/books/9780808033608/epubcfi/6/2
2. http://smallbusiness.chron.com/7-types-corporate-reorganization-17885.html. Retrieved from http:// smallbusiness.chron.com/7-types-corporate-reorganization-17885.html)
3. Http://www.irs.gov/pub/irs-wd/0213003.pdf. Web.