TO: Mr. Jones, Client
FROM: Tax Professional
DATE: June 12, 2011
SUBJECT: Tax Advice
Several organization options were presented. Each option is presented below with the most optimal course of action, from a tax perspective. Each option has various tax benefits and drawbacks. The options will be evaluated independently. The option of outright purchase of Smithon will be evaluated first, followed by the options of merging or acquiring Smithon.
1a.) Should Mr. Jones purchase the stock of Smith outright, leaving Smithon intact? What about issuing debt in his Johnson Services company to pay for the Smith company – would that raise debt to equity issues?
Purchasing the stock of ...view middle of the document...
Would the issue of debt make Johnson Services thinly capitalized?
1b.) Should Mr. Jones convert Smithon to an S corporation and change the fiscal year end to a calendar year end?
An S corporation has some benefits as opposed to a C corporation. An S corporation is not subject to double taxation, as a C corporation. An S corporation is generally required to use a calendar year for its fiscal year, unless there is a specific business need. To that end, changing the fiscal year would not be a problem if Mr. Jones converts Smithon to an S corporation.
However, as Mr. Jones indicated, Smithon is very profitable. Therefore, it would not be in Mr. Jones best interest to convert Smithon to an S corporation. Since the company is profitable, it would not benefit Mr. Jones personally. Also, it would not benefit Johnson Services. The loss that Mr. Jones anticipates for the first two years would not outweigh the benefits of maintaining Smithon as a C corporation.
1c.) What potential income tax ramifications exist for Mr. Jones personally if he purchases the stock of Smithon and converts it to an S corporation?
An S corporation is not a separate taxpaying entity. All income, expenses, gains, losses, etc. are passed through to the owner. In this case, Mr. Jones would be the owner. The income would be taxable at Mr. Jones’ personal tax rate. However, all income, expenses, gains, losses, etc. retain their identity when passed through to the shareholders. Therefore, Mr. Jones could offset personal income with net losses from Smithon. Additionally, Mr. Jones could use any capital losses against his personal capital gains.
However, as Mr. Jones indicated, Smithon is a profitable business. Therefore, Mr. Jones would be taxed for the income of Smithon. As previously mentioned, this could be beneficial for Mr. Jones for the first two years, as they would be operating at a loss. Once Smithon began operating at a gain, Mr. Jones would be taxed for the gain from Smithon’s operations. This could be very detrimental to Mr. Jones personal tax liability.
1d.) Should Mr. Jones merge Johnson Services with Smithon? What type of merger or acquisition would be best?
A Type A reorganization may be Mr. Jones’ best option when evaluating mergers. This would allow Mr. Jones flexibility in payment to Smithon’s shareholders. Unlike the other types of mergers and acquisitions, Mr. Jones could offer the Smithon shareholders nonvoting stock in Johnson Services. This would allow Mr. Jones to retain control of Johnson Services, as well as gain control of Smithon. Additionally, Smithon could sell any unwanted assets, prior to the acquisition. This would prevent Johnson Services from acquiring a lot of unwanted assets. No gain or loss is recognized by Johnson Services. (Code Sec. 1032(a)).
There are some disadvantages to a Type A reorganization. All of Smithon’s liabilities would be assumed by Johnson Services. Shareholders of both...