Luke, Ben, Rey, and Leia decided they want to start a new business together that involved developing software which provided encryption for various mobile devices. Luke and Ben each intended to contribute $110,000 in cash and Rey planned to transfer a small office building that would be used in the business. The land had a tax basis of $70,000 and was appraised at $180,000. The land was also encumbered with a $70,000 nonrecourse mortgage for which no one was personally liable. Leia did not have any assets to contribute to the business, but was going to provide a substantial portion of her time to develop the software, including early uses to generate revenue. They agreed that each individual should receive a 25% share in the future profits and losses of the business.

a. Determine the amount of gain or loss, if any, recognized by each individual and each individuals initial basis in their ownership interest in the business immediately after formation if the business is treated as a general partnership.

b. Determine the amount of gain or loss, if any, recognized by each individual and each individuals initial basis in their ownership interest in the business immediately after formation if the business is treated as an S corporation.

At the end of the first year the business made a $7,000 principal payment on the mortgage. For the first year of operations, the business records disclosed the following information:

Sales revenue $270,000

Operating expenses $70,000

Net rental income $15,000

1231 gains $900

Charitable contributions $300

Municipal bond interest $300

Salary paid to Ben (not included in operating expenses) $3,000

Salary paid to Leia (not included in operating expenses) $10,000

c. List the separate items of business income, gains, losses, and deductions that must show on their individual income tax returns that include the results of the business first year first year of operations based if the business is treated as a general partnership and complete Schedule K of Form 1065.

d. List the separate items of business income, gains, losses, and deductions that must show on their individual income tax returns that include the results of the business first year first year of operations based if the business is treated as an S Corporation and complete Schedule K of Form 1120-S.

e. Determine each individuals adjusted basis in his/her ownership interest in the business at the end of the first year of operations: (1) if the business is treated as a partnership; and (2) if the business is treated as an S corporation.

f. Assume the parties wish to increase Leias percentage interest in the profits of the business for any year that the business realizes a net profit of $1,000,000 or more. If the business reaches that goal, then Leias percentage in the profits would increase from 25% to 30% on the portion of net profit in excess of $1,000,000.

Discuss and explain whether a partnership or S corporation would be the better choice of entity based on the proposed change in allocation of income based on meeting the performance goal.

g. Assume several years pass and Rey decides she wants to leave the business. The parties agree to distribute the building back to Rey in exchange for her interest in the business. The building has a fair market value of $300,000 and a tax basis of $40,000 at the time of the distribution. It is also subject to a $25,000 nonrecourse debt that Rey assumes the obligation to repay. Everyone agrees that the value of Reys interest is $275,000. Her tax basis in her interest in the business is $35,000 if it is taxed as a partnership and $28,750 if it is taxed as an S corporation.

Determine the gain or loss recognized by the business (if any) from the distribution of the building that would pass through to the owners if the business is (1) treated as a partnership, and (2) treated as an S corporation.