Problem 2 Stacey Small has a small salon that she has run for a few years as a sole proprietorship. The proprietorship uses the cash method of accounting and the calendar year as its tax year. Stacey needs additional capital for expansion and knows two people who might be interested in investing. One would like to practice hairdressing in the salon. The other would only invest. Stacey wants to know the tax consequences of incorporating the business. Her business assets include a building, equipment, accounts receivable and cash. Liabilities include a mortgage on the building and a few accounts payable, which are deductible when paid. Write a memo to Stacey explaining the tax consequences of the incorporation. As part of your memo examine the possibility of having the corporation issue common and preferred stock and debt for the shareholders? property and money. Problem 3 Five years ago, Lacey, Kaylee, and Doug organized a software corporation, DLK, which develops and sells Online Meetings software for businesses. DLK is a C corporation. Each individual contributed $10,000 to the company in exchange for 1,000 shares of DLK stock (for a total of 3,000 shares). The corporation also borrowed $250,000 from ACME Venture Capital to finance operating costs and capital expenditures. Because of intense competition, DLK struggled for the first few years of operation and the corporation sustained chronic losses. This year, Lacey, DLK?s president, decided to seek additional funds to finance DLK?s working capital. CME declined to extend additional funds because of the money already invested in DLK. High Tech Venture Capital Inc. proposed to lend DLK $100,000, but at a 10% premium over the prime rate. (Other software manufacturers in the same market can borrow at a 3% premium.) First Round Capital proposed to invest $50,000 of equity capital into DLK, but on the condition that the investment firm be granted the right to elect five members to DLK?s board of directors. Discouraged by the ?high cost? of external borrowing, Lacey decides to approach Kaylee and Doug. Lacey suggests to Kaylee and Doug that each of the three original investors contribute an additional $25,000 to DLK in exchange for five 20-year debentures. The debentures will be unsecured and subordinate to ACME?s debt. Annual interest on the debentures will accrue at a floating 5% premium over the prime rate. The right to receive interest payments will be cumulative; that is each debenture holder is entitled to past and current interest payments before DLK?s board can declare a common stock dividend. The debentures would be both nontransferable and noncallable. Lacey, Kaylee and Doug have asked you, their tax accountant, to advise them on the tax implications of the proposed financing agreement. After researching the issue, issue your advice in a tax research memo. It would be great if you could consult at minimum, you should consult the following authorities: IRC. Sec 385 Rudolph A. Hardman, 60 AFTR 2d 87-5651, 82-7 USTC 9523 (9th Cir., 1987) Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC 9438 (5th Cir., 1967)

Problem 4 Which of the following groups constitute a controlled group? (Any stock not listed below is held by unrelated individuals each owning less than 1% of the outstanding stock.) For brother-sister corporations, which definition applies? Mark owns 90% of the single classes of stock of Hot and Ice Corporations. Johnson and Carey Corporations each have only a single class of stock outstanding. The two controlling individual shareholders own the stock as follows: Stock Ownership Percentages Shareholder Johnson Corp. Carey Corp David 60% 80% Kelly 30% 0% Red, Blue and ABC Corporations each have a single class of stock outstanding. The stock is owned as follows: Stock Ownership Percentages Shareholder Blue Corp. ABC Corp Red 80% 50% Blue 40% Red Corporation's stock is widely held by over 1,000 shareholders, none of whom owns directly or indirectly more than 1% of Red's stock. Helm, Oak, Walnut and Zinnia Corporations each have a single class of stock outstanding. The stock is owned as follows: Stock Ownership Percentages Shareho lder Helm Corp. Oak Corp James 100% Walnut Corp Zinnia Corp 90% 80% 30% Helm Walnut 60% Problem 6 Linda pays $100,000 cash for Jerry's interest in the JILL Partnership. The partnership has a Sec. 754 election effect. Just before the sale of Jerry's interest, JILL's balance sheet appears as follows: Partnership's Basis FMV Assets: Cash $75,000 $75,000 Land $225,000 $325,000 $300,000 $400,000 Jerry $75,000 $100,000 Instrument Corp $75,000 $100,000 Logo Corp $75,000 $100,000 Lighthouse Corp $75,000 $100,000 Total Partners' capital Total $300,000 $400,000 What is Linda's total optional basis adjustment? If JILL Partnership sells the land for its $325,000 FMV immediately after Linda purchases her interest, how much gain or loss will the partnership recognize? How much gain will Linda report as a result of the sale