Question

You are currently working at a mid-sized certified public accounting firm. Your client is Bob Jones. Bob, age 60 and single, has recently retired from IBM. He has $690,000 available in his 401(k) fund and he is thinking of using that money to open a used car business that will be located at 210 Ocean View Drive in Pensacola, Florida. Bob has estimated that the business might make $300,000 in taxable income. Bob’s personal wealth including investments in land, stocks, and bonds is about $14,000,000. He reported an interest income of $20,000 and dividend income of $6,000 last year. The $14,000,000 includes land worth $9,000,000 that Bob bought in 1966 for $450,000. Bob has hired your firm for professional advice regarding whether he should operate as a sole proprietor, a partnership, an S corporation, or a C corporation. He is also considering transferring a possible 40% interest in his new business to his daughter Mandy, age 23 and single.

Required:

A. Identify the tax consequences on the sale or exchange of the land consistent with capital gain rules. Consider the selling expense, broker’s fees, closing costs, appraisals, and surveys and the correct schedule form to complete.

B. Describe the after tax effects on the client’s cash flow based on the sale of the land that is needed to provide the funds necessary to start the business. Consider including capital gains tax rules.

C. Explain whether or not the client and his child should take a salary or cash distribution according to tax purposes and Internal Revenue Code and Treasury regulations. Consider the type of business and the tax effect whether it is salary, dividends, or cash withdrawal

Answer 1

A. Identify the tax consequences on the sale or exchange of the land consistent with capital gain rules. Consider the selling expense, broker’s fees, closing costs, appraisals, and surveys and the correct schedule form to complete.

Answer -

First, Bob had stated he wanted to use the amount he has available in his 401(k) towards the used car business. As per Publication 575, Pension and Annuity Income, considering that Bob’s contributions to the 401(k) may have been pre-tax and he receives the $690,000 in a lump sum, he would not be subjected to the additional tax of 10% given that he is 60 years old, but the entire amount will be treated as ordinary income and will be subject to the maximum tax bracket (39.6%). If he opted for the lump sum, he could end up paying approximately $220,000 and only end up with approximately $440,000 of his pension for investment in his new business.

Second, Bob stated that he has $9,000,000 worth of land. As per Publication 544, Sales and Other Dispositions of Assets, there are various alternatives Bob can consider in order to obtain the most benefit from the sale of his investment properties and acquisition of the potential business location. We did research on the topic and found the following alternatives:

1. Sale of land – Bob can sell portion of the land he owns and use the proceeds towards the new business venture. If he sells at least portion of the land, the capital gains from the sale would be subject to a maximum tax bracket of 20%, which is almost half of what he would be subject to if he would have received the 401(k) lump sum. For example, let’s say that Bob sells all the land he owns for the FMV.

Sale                                                                                         $9,000,000

Less: Cost                                                                                 (450,000)

Capital gain from long-term investments                                 8,550,000

Times: applicable tax bracket                                                           20%

Equals: Tax determined from the sale                                    1,710,000

2. Taxable exchange – Bob can exchange the $5,000,000 worth of stocks and bonds for the property he needs to open his business. This type of transaction is used when the exchange of assets are not similar. The value of the property you receive will be measured using the Fair Market Value and any gain or loss will be recognized in the tax return.

For example, Bob exchanges his stocks and bonds for a building worth $6,000,000.

Fair Market Value of the property received                                       $6,000,000

Less: Book value of the property given up                                           5,000,000

Equal: Capital gain                                                                             1,000,000

Times: Capital gain tax bracket                                                                    20%      

Tax due                                                                                                $200,000

B. Describe the after tax effects on the client’s cash flow based on the sale of the land that is needed to provide the funds necessary to start the business. Consider including capital gains tax rules.

Answer - As per Publication 544, Sales and Other Dispositions of Assets, Bob can sell the lands he owns in order to obtain cash to invest in his new business. He would only be taxed for a 20% of the capital gains resulted from this transaction. Like in the previous example, Sale of Land, if Bob sells the land for $9,000,000, Bob would have to pay $1,710,000 in taxes in relation to this sale, but still have $6,840,000 towards the investment of his new business.

C. Explain whether or not the client and his child should take a salary or cash distribution according to tax purposes and Internal Revenue Code and Treasury regulations. Consider the type of business and the tax effect whether it is salary, dividends, or cash withdrawal

Answer -

1. Corporation – ownership is determined on the amount of stocks purchased. A corporation is considered a separate entity. Profit is taxed when it is earned, and then is taxed to the shareholders when distributed as dividends, creating the double taxation.

In this case I would recommend that Bob and his daughter receive salaries up to the maximum allowable by the IRS. For a corporation, salaries are tax deductible. In other words, setting salaries for them avoids the double taxation on this specific income.

2. Partnerships – It is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skills, and expects to share in the profits and losses of the business. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
3. S corporation – are corporations that elect to pass corporate income, losses, deductions, and credits through their shareholders for federal tax purposes. Shareholders report their portion of the income or losses on their personal income tax return and are assessed tax at their individual income tax rates. This avoids double taxation on the corporate income.

Since both partnerships and S corporations are flow-through entities, both options, salaries and cash distributions, lead to the same result. Both items will be considered ordinary income and would be subject to the normal tax rates.

4. Sole proprietor – is someone who owns an unincorporated business by himself or herself. The income or losses will be reported on the owner’s personal income tax return.

I would recommend to Bob that in benefit of him and his daughter, he should choose to start his new business an S corporation or a partnership in order to avoid the double taxation.