TAXES AND ORGANIZATIONAL FORM:

AN ACTIVITY IN PARTNERSHIP AND CORPORATE ENTITIES

ABSTRACT

This instructional resource presents an integrative approach to understanding tax liability and organizational form in the areas of partnership and corporation formation within a dynamic tax environment. The case demonstrates that the type of entity is very influential in the determination of the tax liability at the entity and owner level. Further, this case enhances critical thinking skills by allowing students to develop and apply their knowledge of: book and tax financial accounting; the tax basis calculations of the ownership interests; and the computation of tax liabilities for each organizational form. The integrative nature of this case is something that is typically not addressed in textbooks or tax courses as it spans both entity and owner levels of analysis. This challenges students to evaluate and compare taxation at the various levels and then synthesize their results for understanding the business relevance. The challenging, integrative nature of the case is representative of the business decisions taxpayers make and helps foster a better understanding of the impact taxes have on business decisions while creating a robust educational environment for the students.

Keywords: Taxes, Organizational Form, Choice of Entity, Individual, Partnership, Corporation

CASE

Entity Formation and Taxation

Ridge Development Group is formed on June 1 by John Parks and Sue Jones to operate as a calendar year accrual basis company that develops and markets land to customers. John will contribute land with a fair market value of $1,000,000, an adjusted tax basis of $650,000, and a $400,000 nonrecourse bank loan incurred to purchase the land, for an interest in the company. The land was purchased by John three years ago and has been held as an investment. Sue will contribute shares of stock in Frontier Corporation with a fair market value of $200,000 and an adjusted tax basis of $125,000 and shares of stock in Yukon Corporation with a fair market value of $200,000 and an adjusted tax basis of $210,000, for an interest in the company. Sue purchased both blocks of stock 15 months ago as an investment.

If Ridge Development Group is organized as a corporation, John will receive 56% of the shares of stock for his interest and Sue will receive 44% of the shares of stock for her interest after factoring in Ridge Developments deferred tax liability. Alternatively, if organized as a limited liability company taxed as a partnership, John will receive a 60% interest and Sue a 40% interest in Ridge Development Group.

Ridge Development Group then proceeded to sell 30% of the land for $350,000 on October 20^th, all of the shares of stock in Frontier Company for $215,000 on December 10^th, and incurred selling and administrative expenses of $50,000 (all related to land sale), which is paid in cash before the end of the year. Ridge also distributed a total of $90,000 to John and Sue based on their proportional ownership on December 20th. Both John and Sue are single, between the ages of 40 50, with no dependents, and each has wages of $110,000 from outside sources. Assume the current year corporate and individual tax rates and refer to the Qualified Dividends and Capital Tax Worksheet, Form 8960 (Net Investment Income Tax) and Form 8959 (Additional Medicare Tax) for the calculation of taxes.

Questions for Analysis

Corporate Questions

C1) Prepare a schedule calculating the initial tax basis for John and Sue for the ownership interest in Ridge Development Group when it is formed as a corporation (stock basis). What is the holding period for John and Sue?

C2)Will John or Sue be required to recognize any gain on the exchange of their property for stock in the corporation?

C3)Prepare the initial and year-end US GAAP and tax balance sheets for Ridge Development Group when it is formed as a corporation. Also prepare the US GAAP and tax income statements for the corporation. Note: You will have to calculate the deferred tax liability[1] at the time of the formation (assume a 34% tax rate) and adjust the deferred tax liability at year-end. The stock ownership is 56% for John and 44% for Sue. (Show all your work.)

C4)If Ridge Development Group was organized as a corporation, identify the different types of taxes that apply and analyze the tax implications for the entity and stockholders (John and Sue). More specifically, calculate the federal tax liability that would apply at the entity level and individual level (this includes income tax and net investment income tax). Is there any change in the shareholders stock basis? (Show all your work.)

Tables to use in Case and Additional Information:

Following are some guidelines and tables that should help you with the case. Be sure to support your answers with tax codes and calculations.

C1) No issues, should be straight forward.

Use the following table (fill in the ?):

	?	John	Sue
Carryover basis	?	?	?
Gain Recognized	?	?	?
Less: Bank Loan	?	?	?
Stock Basis		?	?

C2) No Issues, should be straight forward.

C3) US GAAP: ASC 805-740-25-3 and ASC 740-10 require the contributed assets be recorded at FMV with a deferred tax liability (DTL) attributable to the difference in the FMV and the tax basis on the date of the contribution multiplied by the corporate tax rate.

Total DTL is 141,100 but you must know how much of that is for John and how much is for Sue.

Even though Common Stock is one number on the balance sheet (plug to balance the B/S), you must know the amount for each shareholder (i.e., John and Sue). Individual amounts are calculated as FMV of contribution (net of debt) less the each individual DTL.

Use the following format (Table) for the 6/1/XX Balance Sheet:

Balance Sheet: 06/01/XX
		US GAAP	Tax
Cash
Land - Inventory
Frontier Stock - Investment
Yukon Stock - Investment
Total Assets
Nonrecourse Bank Loan
Deferred Tax Liability
Common Stock
Retained Earnings
Total Liabilities & Stockholders Equity

Income Statement:	12/31/XX	Income Statement:	12/31/XX
	US GAAP		TAX
Land Sale Price		Land Sale Price
COGS		Land Tax Basis
Gross Profit		Gross Profit
Selling & Admin Expense		Selling & Admin Expense
Gain on Stock Sale		LTCG Stock Sale
Income before tax		Taxable Income
Federal Tax Benefit*		Federal Income Tax*
Income After Tax	$16,900	Current E&P	$135,700
Distribution		Distribution
Ending R/E		Accum. E&P

* You must show your calculation on how the Federal Tax Benefit and the Federal Income Tax is calculated. Since the land and one stock has been sold, the DTL has changed. Total DTL at year end is $79,900 (please identify what is related to the remaining land John contributed and the remaining stock Sue contributed)

Tax Entries (these will help understand the Federal Tax Benefit and the yr.end B/S):

DTL ?

Income Tax Payable ?

Income Tax Expense

Income Tax Payable ?

Cash ?

Balance Sheet: 12/31/XX
		US GAAP	Tax
Cash
Land - Inventory
Frontier Stock - Investment
Yukon Stock - Investment
Total Assets		1,265,700	1,030,700
Nonrecourse Bank Loan
Deferred Tax Liability
Common Stock
Retained Earnings
Total Liabilities & Stockholders Equity		1,265,700	1,030,700

C4) Your tax liability for the corporate entity will be answered in C3). In addition, the shareholders, John and Sue will have a tax expense on their Form 1040. Remember, the tax rates for dividends is different form their earned income rates. Use the following table:

12/31/XX	John	Sue
AGI before dividend
Dividend Distribution
AGI
Standard Deduction	(6,100)	(6,100)
Exemption	(3,900)	(3,900)
Taxable Income
Federal Income Tax