Question 1 Galadriel Elvin, a wealthy entrepreneur, was returning home after taking the eldest of her three children to start college on the other side of the country when she noticed that the person sitting next to her in the first-class cabin was absentmindedly fiddling with a pink substance. When she asked about it, Bill Halfacre explained that he had developed it because he was spending a small fortune on batteries for his young childrens toys. Simply dipping regular alkaline batteries in the substance for an hour had proven to more than double the effective life of the batteries. When Galadriel mentioned that this was a great idea, Bill replied that he was a bit depressed because he had been trying to connect with someone who could help him develop and market the product, but had been unsuccessful. Galadriel encouraged him, and discovered that he had lived a varied and interesting life. He had earned several degrees in chemistry, but had spent all his time since graduating surfing throughout the world, and tinkering with various inventions. (He had inherited enough money that he had not had to work since he finished school five years ago, but the money was running out.) By the time the plane landed, Galadriel and Bill had set a time to meet with Galadriel's lawyer, Elsa Treebeard, to discuss a venture to market Bill's products. They also invited one of Galadriel's colleagues, Jim Pippin, to attend the meeting. Jim had worked with Galadriel on several occasions: he makes a lot, but keeps very little, money. He is a marketing whiz who has strong connections to several distributors to large office supply outlets. Galadriel's concern with Jim has always been that he plays things a bit fast and loose. At the meeting, the group developed projections of profits and losses for the first five years of the business. The expectation is that annual losses will range from $100,000 to $200,000 over these five years, with break-even in about Year 5. The business will be capitalized with about $200,000 in cash, along with computers, equipment, furniture, and fixtures (fair market value of $100,000 and basis of $25,000) contributed by Galadriel. Bill will contribute the patent at an agreed value of $150,000. Jim has nothing to contribute but time. He will receive a 25% interest for contributing all of his time for a year to get the business going. Thereafter, he will be compensated based on sales and profits. Elsa believes they will be able to borrow $200,000 initially and perhaps an additional $100,000 per year during the development period. The money will be used for working capital and manufacturing equipment. They feel that they may be able to attract new investors once some of the initial work has been completed. Galadriel thinks Jim brings some needed talents to the venture, but she is very uneasy about being exposed to liabilities that he might create. Bill says he has nothing to lose so the association with Jim does not concern him. Galadriel has about $500,000 in income each year. Bill's income is about $25,000 a year and Jim has earned anywhere from $0 to $200,000 annually over the last few years. How might taxes impact the results of the major strategic decisions faced by the three venturers as they start up the business?

Question 2 Benoit Pharmaceuticals, Inc. was formed in 1990 by Richard Benoit, PhD. Formerly a research scientist with a major pharmaceutical, he decided to strike out on his own. He owned 100% of the stock of the Princeton, New Jersey based manufacturer. The firm had been hugely successful by manufacturing aspirin and acetaminophen products. Flush with cash, Benoit felt that it was the time to take a chance on a product that might be a home run. Two researchers at Johns Hopkins had been doing promising work in oncology, and might be able to develop some effective cancer treatments. He felt that he could hire them away, set up an R&D facility, and within five years get back 10 times his investment. The scientists plus support staff would earn $500,000 per year, annual operating costs would be another $100,000, and an up-front investment of $1 million in lab equipment would be necessary. His tax consultant estimated that a $400,000 tax benefit would occur in the first year, with $200,000 in tax benefits occurring in each of the next five years. The tax benefits would come primarily from a tax credit for research and development. The investment was risky, with an industry average success rate of 50% in oncological products. Although there was enough free cash flow to finance the investment internally, Benoit preferred to finance it with external financing. Borrowing would be at 12%. Or he could spin the R&D operation off into a separate subsidiary, issuing stock to venture capitalists. The venture capitalists would expect an eventual return of 200%. If the subsidiary were formed as a partnership, some of the tax benefits might flow through to the venture capitalists. What would you recommend? Question 3 1. You are the in-charge accountant for an attestation engagement when a tax issue arises. Your S corporation client, which previously had positive taxable income, has incurred a $1 million new operating losses. The two shareholders each have a tax basis in their stock of $300,000. What will happen to the excess tax losses? How might you advise your client to utilize these losses? How would this advice fit with the SAVANT concept? 2. One of your clients is a plastic surgeon in a highly lucrative practice with four other plastic surgeons. Together, the net income for the practice is $20 million. Assume that taxable income is about one half of this amount, that the firm (a corporation) has not paid dividends in its five-year history, and the surgeons have paid themselves salaries of $100,000 per year (each). What tax problems might arise? How could they be remedied?