Case XV

Hawaiian Memories, Inc. (HMI) is a C corporation that was formed in 2010 in Maui. The company markets specialty tourism products of the islands of Hawaii. The initial incorporators were Angie Lee and Bob Lin, who now own 1,000 shares of voting common stock and 100 shares of preferred stock each. The company has eight employees who collectively own 500 shares of nonvoting stock. Most of the employees have worked for the company for several years. They purchase the stock when the company offers it at the end of each year. Two employees own 100 shares each; the other six own 50 shares each.

None of the HMI shareholders are related to each other by blood or marriage, except for Angie and Bob. All individual shareholders are native Hawaiians except for Inge; she is a Swedish citizen and has lived on Maui and worked for HMI for three years. Inge plans to move back to Sweden in one year and try to develop markets for HMI products there.

Another stockholder is the Plantation Sugar Partnership (PSP). PSP owns 500 nonvoting common shares; it supplies raw sugar in bulk to HMI. Bob Lin and his sister Katie each own 50% of PSP.

PwC Case Studies in Taxation, 2015, PwC, LLP

Plantation Sugar Partnership

500 non-voting common

Angie

1,000 voting common 100 preferred

Hawaiian Memories Inc

Bob

1,000 voting common 100 preferred

Carl, Donna

100 non-voting common each

Ernie, Frank, Gertie, Hannah, Inge, Jerry

50 non-voting common each

Bob

50%

Katie

50%

The corporation uses a June 30 year end. All of the HMI shareholders use calendar years. Financial statements for the year ended June 30, 2014 are attached. HMI does not expect that it will generate any significant increases in investment or passive activity income in the coming years.

This was the first year of corporate operating losses in some time. The corporation elected not to carry back the losses because the tax rate paid in those years was lower than they expect to pay in the future. Bob and Angie expect one or two more years of losses and then steady increases in a positive amount of net income.

Bob lives in Hawaii and manages operations there. Angie moved to San Francisco in 2011 to develop mainland markets for their products. Both earn annual salaries of $150,000. The shareholders and all

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HAWAIIAN MEMORIES, INC.

employees are provided accident and health insurance. The company contributes 10% of each employee's salary to a defined contribution pension plan each year.

I

On October 1, 2014, Bob and Angie came to your office for the first time. They have just filed the corporate return for the fiscal year ended June 30, 2014 and are interested in having you take over all the future tax work for the corporation. They inform you that they have just read an article in Tourism Retailing about the tax and cash-flow benefits of pass-through losses. They have filed an election to be an S corporation, effective on July 1, 2014.

Bob and Angie signed the consent for the S election because they were the only shareholders with voting stock. Their reasoning for making the S election is that they expect losses for a year or two as they try to expand, and they would like to use the losses already incurred as well as the prospective losses against their other income. Review all relevant information and identify any issues related to an HMI conversion to S status. Advise Bob and Angie about electing S status.

II

Now instead assume the following: Memories elected S status, effective for the taxable year beginning July 1, 2015. HMI had wanted to keep its fiscal year, but it could not document significant seasonality. So the first S tax return will be for six months, reflecting the new calendar tax year.

A C corporation return was filed for the fiscal year ending June 30, 2015. That return showed a zero taxable income for current year operations.

The balance sheet for June 30, 2015 only differs from the June 30, 2014 statement as presented by $40,000 additional depreciation deductions claimed. HMI plans to sell the investment land in 2016 to raise cash, because Bob and Angie feel that the appreciation potential in the land will have flattened by then. They expect the property to be worth about $1,000,000 in 2016.

Angie and Bob anticipate that there will be net tax losses from operations of $200,000 during the six- month period ending December 31, 2015. Projected operating losses for calendar tax year 2016 total $150,000, without consideration of the land sale.

Convey to HMI the tax effects of such a 2015 conversion to S status. Provide a restated HMI balance sheet as of June 30, 2015, and compute the passthrough to the shareholders for the 2016 HMI calendar year.

PwC Case Studies in Taxation, 2015, PwC, LLP HAWAIIAN MEMORIES, INC. Hawaiian Memories, Inc. (HMI) is a C corporation that was formed in 2010 in Maui. The company markets specialty tourism products of the islands of Hawaii. The initial incorporators were Angie Lee and Bob Lin, who now own 1,000 shares of voting common stock and 100 shares of preferred stock each. The company has eight employees who collectively own 500 shares of nonvoting stock. Most of the employees have worked for the company for several years. They purchase the stock when the company offers it at the end of each year. Two employees own 100 shares each; the other six own 50 shares each. None of the HMI shareholders are related to each other by blood or marriage, except for Angie and Bob. All individual shareholders are native Hawaiians except for Inge; she is a Swedish citizen and has lived on Maui and worked for HMI for three years. Inge plans to move back to Sweden in one year and try to develop markets for HMI products there. Another stockholder is the Plantation Sugar Partnership (PSP). PSP owns 500 nonvoting common shares; it supplies raw sugar in bulk to HMI. Bob Lin and his sister Katie each own 50% of PSP. Hawaiian Memories Inc Plantation Sugar Partnership 500 non-voting common Bob Katie 50% 50% Angie Bob Carl, Donna Ernie, Frank, Gertie, Hannah, Inge, Jerry 1,000 voting common 100 preferred 1,000 voting common 100 preferred 100 non-voting common each 50 non-voting common each The corporation uses a June 30 year end. All of the HMI shareholders use calendar years. Financial statements for the year ended June 30, 2014 are attached. HMI does not expect that it will generate any significant increases in investment or passive activity income in the coming years. This was the first year of corporate operating losses in some time. The corporation elected not to carry back the losses because the tax rate paid in those years was lower than they expect to pay in the future. Bob and Angie expect one or two more years of losses and then steady increases in a positive amount of net income. Bob lives in Hawaii and manages operations there. Angie moved to San Francisco in 2011 to develop mainland markets for their products. Both earn annual salaries of $150,000. The shareholders and all Page 1 of 4 PwC Case Studies in Taxation, 2015, PwC, LLP HAWAIIAN MEMORIES, INC. employees are provided accident and health insurance. The company contributes 10% of each employee's salary to a defined contribution pension plan each year. I On October 1, 2014, Bob and Angie came to your office for the first time. They have just filed the corporate return for the fiscal year ended June 30, 2014 and are interested in having you take over all the future tax work for the corporation. They inform you that they have just read an article in Tourism Retailing about the tax and cash-flow benefits of pass-through losses. They have filed an election to be an S corporation, effective on July 1, 2014. Bob and Angie signed the consent for the S election because they were the only shareholders with voting stock. Their reasoning for making the S election is that they expect losses for a year or two as they try to expand, and they would like to use the losses already incurred as well as the prospective losses against their other income. Review all relevant information and identify any issues related to an HMI conversion to S status. Advise Bob and Angie about electing S status. II Now instead assume the following: Memories elected S status, effective for the taxable year beginning July 1, 2015. HMI had wanted to keep its fiscal year, but it could not document significant seasonality. So the first S tax return will be for six months, reflecting the new calendar tax year. A C corporation return was filed for the fiscal year ending June 30, 2015. That return showed a zero taxable income for current year operations. The balance sheet for June 30, 2015 only differs from the June 30, 2014 statement as presented by $40,000 additional depreciation deductions claimed. HMI plans to sell the investment land in 2016 to raise cash, because Bob and Angie feel that the appreciation potential in the land will have flattened by then. They expect the property to be worth about $1,000,000 in 2016. Angie and Bob anticipate that there will be net tax losses from operations of $200,000 during the sixmonth period ending December 31, 2015. Projected operating losses for calendar tax year 2016 total $150,000, without consideration of the land sale. Convey to HMI the tax effects of such a 2015 conversion to S status. Provide a restated HMI balance sheet as of June 30, 2015, and compute the passthrough to the shareholders for the 2016 HMI calendar year. Page 2 of 4 PwC Case Studies in Taxation, 2015, PwC, LLP HAWAIIAN MEMORIES, INC. Hawaiian Memories, Inc. Book/Tax Balance Sheet June 30, 2014 Book / Tax Basis Fair Market Value $ $ Assets Cash Trade accounts receivable Inventory (LIFO) Furniture and fixtures FIFO cost/basis would be $450,000 100,000 250,000 100,000 250,000 350,000 500,000 180,000 350,000 100,000 850,000 $ 1,230,000 $ 1,800,000 $ 300,000 Accumulated depreciation (120,000) Investment land Total Liabilities and Shareholders' Equity Accounts payable Note payable, Hawaiian National Bank Paid-in capital, common Nonvoting, cumulative 8%, callable at Paid-in capital, preferred 104% of face Retained earnings Total $ 145,000 200,000 $ 500,000 100,000 600,000 285,000 $ 1,230,000 Notes The difference between FIFO and LIFO is expected to be approximately the same for the next year. The entire layer of inventory on hand at conversion will be sold by December 31, 2015. Memories' balance in Accumulated Earnings and Profits (E&P) is $300,000. Current E&P for the year ended June 30, 2015 was $0. Page 3 of 4 PwC Case Studies in Taxation, 2015, PwC, LLP HAWAIIAN MEMORIES, INC. Hawaiian Memories, Inc. Book and Tax Income Statement for the 12 months ending June 30, 2014 Revenues / Gross Income Sales Interest income $1,650,000 10,000 $ 1,660,000 Expenses / Deductions Cost of goods sold Salaries, Angie and Bob Salaries, other employees Employment taxes Rent expenses Depreciation Employee health care Contributions to employee retirement plans Other operating expenses Net Loss $1,094,000 $ 300,000 200,000 $ 500,000 50,000 36,000 40,000 85,000 45,000 130,000 55,000 1,905,000 $ (245,000) Page 4 of 4