Chapter 3: Organizational Strategies
Questions and Problems for Discussion
1. In a general partnership, all partners have unlimited personal liability for the entity’s business debts. In a limited partnership, only the general partner (or partners) has unlimited personal liability. The limited partners have no personal liability for the entity’s debts. In an LLP, a partner has no personal liability for claims against the entity arising from the malpractice or professional misconduct of any other partner. However, LLP partners have unlimited personal liability for the entity’s other debts. In an LLC, no member has personal liability for the entity’s business debt.
2. The nontax advantage of operating a business as a single-member LLC instead of a sole proprietorship is that the individual owner has limited liability for business debts. Because a single-member LLC is treated (by default) as a sole proprietorship for federal tax purposes, there is no tax advantage to a single-member LLC over a sole proprietorship.
3. The nontax advantage of operating a business as an LLC instead of a limited partnership is that all owners (members) have limited liability for business debts. In a limited partnership, only the limited partners have limited liability. Because an LLC is treated (by default) as a partnership for federal tax purposes, there is no tax advantage to an LLC over a limited partnership.
4. If a closely held corporation accumulates its after-tax income instead of paying dividends, the value of the corporate business should increase. The increased value of the business should be reflected in an increased value (market price) of the corporate stock. If and when a shareholder disposes of stock in a taxable transaction, the shareholder will recognize the increased stock value as a capital gain. The shareholder tax on this capital gain is an indirect second tax on the accumulated corporate income.
5. Dividends are fully included in individual taxable income (and taxed at a preferential rate). While dividends are fully included in corporate gross income, the dividend-received deduction significantly reduces (or even eliminates) the amount of dividends included in the recipient corporation’s taxable income.
6. The Section 351 nonrecognition rules contain an 80 percent control requirement, while the Section 721 nonrecognition rules have no control requirement. Section 351 applies only to the transferor of property (shareholder) in the property-for-stock exchange, while Section 721 provides nonrecognition to both the transferring partner and the partnership. Section 351 provides that the transferor’s receipt of boot triggers gain recognition in the property-for-stock exchange, while Section 721 has no boot provision.
7. A substituted basis in an asset is determined by reference to the basis of a different asset. A carryover basis in an asset is the same basis that the asset had in the hands of a different taxpayer.
8. The following factors suggest that purported shareholder debt is disguised equity. The debt is not evidenced by a written loan document or other legal evidence of indebtedness. The debt does not have a specific repayment schedule or date. The debt does not provide for a market rate of interest. The debt is held by the shareholders in the same proportion as the corporation’s stock. Shareholder debt is subordinated to nonshareholder debt. The debt is unsecured. The corporation has failed to make interest and principal payments on the debt on a timely basis.
9. A partner’s capital interest is a claim on the net book value of partnership property as evidenced by a positive balance in the capital account. A partner’s profit and loss interest is the partner’s right to a share of future (unrealized) partnership income, gains, expenses, and losses.
10. The term outside basis refers to the tax basis in a partner’s interest in the partnership (an intangible financial asset). The term inside basis refers to the partnership’s tax basis in its property.
11. A transferor of property in a Section 351 exchange must recognize gain realized to the extent of the FMV of any boot (nonqualified property) received in the exchange. A transferor of property in a Section 721 exchange that receives a distribution of other partnership property in connection with the transfer may be required to treat the transfer as a part nontaxable contribution/part taxable sale under the Section 707(a) disguised sale rules.
12. If Ms. Ames personally guarantees the loan and has no legal recourse against any other member, she bears the entire economic risk of loss with respect to the LLC debt. Consequently, the entire $50,000 LLC debt is included in Ms. Ames’s outside basis in her LLC interest.
13. If the shareholder has a lower marginal tax rate than the corporation, the lease transaction reduces the aggregate income tax burden by creating rental income to the shareholder and a corresponding deduction for rent expense to the corporation. This planning strategy reflects the maxim that “tax costs decrease (and cash flows increase) when income is generated by an entity subject to a low tax rate.”
Application Problems
4. a. The FMV of the 50 shares is $45,000.
b. Mr. Smith realized a $14,000 gain, and Ms. Litwin realized a $27,000 gain. Because Mr. Smith and Ms. Litwin had 100 percent control of SL Inc. immediately after their property-for-stock exchange, Section 351 applies and neither recognizes any gain.
c. Mr. Smith’s substituted basis in his 50 shares is $31,000, and Ms. Litwin’s substituted basis in her 50 shares is $18,000.
d. SL’s book basis in the business property contributed by each transferor is $45,000. SL’s carryover tax basis in Mr. Smith’s property is $31,000 and its carryover tax basis in Ms. Litwin’s property is $18,000.
6. a. The FMV of each share of stock is $1,200.
b. Mrs. Sims realized a $4,000 gain, Mrs. Tan realized a $3,000 loss, and Mr. Underhill realized an $18,000 gain. Because the three transferors had 100 percent control of STU Inc. immediately after their property-for-stock exchange, Section 351 applies and the transferors recognize no gain or loss.
c. Mrs. Sims’s substituted basis in her 25 shares is $26,000, Mrs. Tan’s substituted basis in her 50 shares is $63,000 (including $10,000 contributed cash), and Mr. Underhill’s substituted basis in his 25 shares is $12,000.
d. STU’s book basis in the property contributed by Mrs. Sims is $30,000, and its carryover tax basis is $26,000. STU’s book basis in the property contributed by Mrs. Tan is $50,000, and its carryover tax basis is $53,000. STU’s book basis in the property contributed by Mr. Underhill is $30,000, and its carryover tax basis is $12,000.
7. a. Mr. Underhill’s realized gain is $18,000, and his recognized gain is $4,800.
b. Mr. Underhill’s basis in his 25 shares is $12,000 ($12,000 substituted basis - $4,800 boot received + $4,800 gain recognized).
c. STU’s book basis in the property contributed by Mr. Underhill is $30,000, and its tax basis is $16,800 ($12,000 carryover basis + $4,800 gain recognized by Mr. Underhill).
8. a. Mrs. Sims realizes and recognizes a $4,000 gain on the exchange.
b. Mr. Sims’s basis in her 25 shares is $25,200 ($26,000 substituted basis - $4,800 boot received + $4,000 gain recognized).
c. STU’s book basis in the property contributed by Mrs. Sims is $30,000, and its tax basis is $30,000 ($26,000 carryover basis + $4,000 gain recognized by Mrs. Sims).
9. a. Mr. Badgett will receive stock with a $460,000 FMV (net value of the business assets transferred) plus $40,000 relief of liability in exchange for property with a $312,000 basis. Thus, he will realize a $188,000 gain on the exchange. Because Section 351 applies and the relief of liability is not considered boot, he will not recognize any gain.
b. Mr. Badgett’s basis in his 100 shares will be $272,000 ($312,000 substituted basis - $40,000 relief of liability). The corporation’s tax basis in the business assets will be a $312,000 carryover basis.
c. The $40,000 relief of liability exceeds the $27,750 basis in the contributed property by $12,250, which Mr. Badgett must recognize as taxable gain. The basis in his 100 shares will be zero ($27,750 substituted basis - $40,000 relief + $12,250 gain recognized), and the corporation’s tax basis in the business assets will be $40,000 ($27,750 carryover basis + $12,250 gain recognized by Mr. Badgett).
10. a. Ms. Olan received stock with a $715,000 FMV (net value of the business assets transferred) plus $87,000 relief of liability in exchange for property with a $574,000 basis. Thus, she realized a $228,000 gain on the exchange. Because Section 351 applies and the relief of liability is not considered boot, she does not recognize any gain.
b. If the corporation’s assumption of Ms. Olan’s $12,000 unsecured debt has no business purpose, her entire $87,000 relief of liability is treated as boot received in the property-for-stock exchange. Consequently, she must recognize $87,000 of her $228,000 realized gain.
11. a. Because Mr. Pride did not take a deduction for the accrued rent or interest payable, these liabilities are ignored for purposes of computing any realized gain on the incorporation. Thus, Mr. Pride does not recognize any gain because the $50,000 note payable assumed by PPX Inc. does not exceed his $53,200 aggregate tax basis in the contributed business assets.
b. Mr. Pride’s basis in his PPX stock is $3,200 ($53,200 substituted basis – $50,000 relief of liability).
14. a. Here is LK Partnership’s initial balance sheet.
Book Basis Tax Basis
Cash $100,000 $100,000
Contributed equipment 30,000 40,000
Contributed land 70,000 20,000
$200,000 $160,000
Capital: Ms. Lowinsky $100,000 $60,000
Mrs. Kormera 100,000 100,000
$200,000 $160,000
b. Ms. Lowinsky realized a $40,000 net gain on the transfer of property in exchange for her partnership interest. Because Section 721 applies to the exchange, she does not recognize any gain. The outside basis in her partnership interest is a $60,000 substituted basis.
c. Mrs. Kormera’s outside basis in her partnership interest is $100,000.
16. a. Toby Inc. is treated as selling a portion of the investment land for an amount realized of $200,000. Toby’s adjusted basis in this portion is $70,000 ($210,000 basis ´ [$200,000 amount realized/$600,000 FMV of land). Thus, Toby must recognize a $130,000 gain on sale.
b. Toby’s outside basis in its LLC interest is $175,000 ($140,000 basis of contributed portion of land + $35,000 share of LLC mortgage).
c. Harrison’s book basis in the investment land is $600,000. Its tax basis is $340,000 ($200,000 cost of purchased portion + $140,000 carryover basis of contributed portion).
18. a. Mr. Habib realized a $150,000 gain on the exchange of real estate for a partnership interest. Because Section 721 applies, he did not recognize any gain.
b. Mr. Habib’s outside basis in his Mega interest is $176,400 ($250,000 substituted basis + $26,400 (20%) share of partnership liabilities - $100,000 relief of recourse mortgage).
c. Mr. Habib would still not recognize any gain on contribution of the real estate. However, he must recognize gain to the extent that his relief of the recourse mortgage exceeds his outside basis.
Substituted basis of contributed real estate $45,000
20% share of partnership recourse liabilities 26,400
Relief of mortgage (100,000)
Excess relief $(28,600)
Mr. Habib must recognize a $28,600 gain and take a zero basis in his Mega interest.
d. If Mega is an LLC, no member has personal liability for LLC liabilities, and all Mega’s liabilities (including the mortgage assumed from Mr. Habib) are nonrecourse. Consequently, Mr. Habib’s share of the mortgage consists of a $55,000 preemptive share (excess of nonrecourse mortgage over contributed basis) plus 20 percent of the $45,000 remaining mortgage. Consequently, Mr. Habib has no excess relief and no recognized gain. The outside basis in his Mega interest is computed as follows.
Substituted basis of contributed real estate $45,000
Share of mortgage:
Preemptive share 55,000
20% share of remaining mortgage 9,000
20% share of other LLC liabilities 6,400
Relief of liability (100,000)
Outside basis in Mega interest $15,400
20. a. Mr. Lauer’s outside basis in his Isaax interest is computed as follows.
Substituted basis of contributed land $111,300
25% share of mortgage 25,000
Relief of mortgage (100,000)
Outside basis $36,300
b. Mr. Lauer’s outside basis in his Isaax interest is computed as follows.
Substituted basis of contributed land $111,300
Preemptive share of mortgage
($160,000 - $111,300) 48,700
25% share of remaining mortgage 27,825
Relief of mortgage (160,000)
Outside basis $27,825
21. a. Mr. Trent can recognize the $40,000 loss realized on sale. TV has a $100,000 cost basis in the land for both book and tax purposes.
b. Because of family attribution, Mr. Trent directly and indirectly owns a 65 percent interest in TV. Because the sale is to a related party, Mr. Trent’s $40,000 realized loss is disallowed. TV has a $100,000 cost basis in the land for both book and tax purposes.
c. TV’s book gain on sale is $61,500 ($161,500 amount realized - $100,000 cost basis). TV can reduce the tax gain on sale by Mr. Trent’s $40,000 disallowed loss. Consequently, TV’s tax gain is only $21,500.
22. a. Conroe LLC will recognize an $800,000 capital gain on sale of the land, and CFG Ltd. will have a $1,200,000 cost basis in its inventory.
b. Although Mr. and Mrs. Conroe control Conroe LLC, they do not own a controlling interest in CFG Ltd. Consequently, Conroe will recognize an $800,000 capital gain on sale of the land, and CFG Ltd. will have a $1,200,000 cost basis in its inventory.
c. Mr. and Mrs. Conroe own more than 50 percent of both Conroe LLC and CFG Ltd. Because the two entities are related parties, Conroe will recognize an $800,000 ordinary gain on sale of the land, and CFG Ltd. will have a $1,200,000 cost basis in its inventory.
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