Part 1

In 2018, Sally, a single woman who operates her business as a sole proprietor, is considering switching over to a C-Corporation on January 1, 2019. She estimates her 2019 sales will be $500,000 and COGS will be $150,000. If she does switch over, she estimates her other three expenses will be slightly different. The first expense, her business liability insurance, will decrease from $25,000 to $5,000 due to needing less liability protection in corporate form. The second expense, your tax preparation fee, will increase from $10,000 to $20,000 since two tax returns will now be due (Form 1040 + form 1120). Assume all tax preparation fees you charge Sally are 100% tax deductible. The third expense, employee wages, is estimated to be $50,000 for her one employee, Sam. However, since Sally will be working for the corporation, she'll be required to pay herself a wage, which is typical wage of a CEO of a business her size of $100,000, thus as a C-corporation you'll have $150,000 in wage expense. For simplicity's sake, assume all income, other than dividend income, reported on Form 1040 is taxed at a flat rate of 37%. Further assume she always elects to take the standard deduction.

Sally asks you, as her tax accountant, to estimate the differences in her after-tax income if she remains a sole proprietor versus becomes a C-corporation. If she becomes a C-corporation, she'll pay herself a normal wage and all remaining income left in the C-Corporation will be paid out as a dividend to Sally. Ignore all payroll taxes (of both Sam and Sally) and assume dividend income is qualified dividend income and will all be taxed as long-term capital gain rates. Further assume that Sally is neither a low-income nor a high-income taxpayer (i.e., all her dividend income will all be taxed at the same rate).

Requirement - Scenario 1A: Calculate the cost comparison in MS Excel showing all your work. Be sure to summarize Sally's total tax expense (be sure to include tax on both the 1040 as well as on the 1120, if applicable) and her after-tax cash flow. The first column should show if she stays a sole proprietor and the second column should show if she switches over to a C-corporation. Explain which scenario is financially better for Sally and why.

Note: You, as the smart student that you are, asked Sally what line of business her business income is derived from and she tells you "Engineering."

Requirement - Scenario 1B: A few days after you sent Sally your recommendation and cost summary sheet, you go out to lunch together and you reminisce about how hard the CPA exam was and she reminisces about how hard the bar exam was. You ask if she's a lawyer than why does she have an engineering firm? She explains you must have misunderstood her, that she's not an engineering firm, but a lawyer who provides legal services and most of her clients happen to be engineers. Would that minor detail impact the conclusion made in Scenario 1A? If your recommendation would have changed, show the changes to the calculations

Requirement - Scenario 1C: A few days after you completed your analysis, Sally informs you she is planning to get married to Sam, her sole employee. She explains that she plans to get married soon and thus in 2019 she will file a married filing joint tax return with him. Update your calculations and review whether Sally should stay a sole proprietorship or switch to a C Corp. If your recommendation from Scenario 1A changes, explain why.

Part 2

Irrespective of your calculations from Part 1, and whether it makes financial sense, Sally decides to become a C-corporation. On January 1, 2019 Sally plans to transfer her office building for stock in a C-corporation. The office building has a FMV of $1,000,000, and adjusted basis of $250,000, and a lien on the building of $230,000. The C-corporation would assume the loan. There are two options she is contemplating:

Option 1 is to form a new C-corporation, called Lawgineering, in which she would transfer her office building to the C-corporation in exchange for receiving 100% of its stock.

Option 2 is to join an existing C-corporation, called Enginlawing, which is owned by Trevor who currently owns 100% of its stock. In this transaction, Sally would transfer her office building to the existing C-corporation in exchange for receiving 87% of its outstanding stock plus a Nancy Pelosi Impeachment Pen. Enginlawing originally acquired the pen for $20,000 and it has a FMV of $100,000 on the date of the transfer.

Requirement - Scenario 2A: Calculate a cost summary comparison in Excel between Options 1 and 2. Specifically, show what Sally's realized gain, recognized gain, stock tax basis, and pen basis (if applicable) will be in both scenarios. Will the corporation will have any realized gain or recognized gain? If so, what is the corporation's basis in the building will be in both scenarios? The first set of columns in Excel should show if Option 1 and the second set of columns should show Option 2. After calculations, which option (1 or 2) makes the most financial sense and why.

Requirement - Scenario 2B: Assume Sally made an error on some numbers and the lien amount was actually $320,000 and not $230,000. Update your calculations and explain whether these errors are material and have any financial impact.

Requirement - Scenario 2C: You get a call from Sally that she thinks she may be dyslexic because she told you in Option 2 she would get an 87% stake in Enginlawing after the exchange but it will actually be 78%. Since either way she has over 50% control and therefore it doesn't change Trevor's ability to outvote her, she figures it doesn't matter but, requests updated calculations in excel. Explain whether this change of information has any change on the situation and why.