John Ralph's Corporations: liquidation issues, estate planning
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John Ralph owns The Ralph Construction Company (RCC), a C corporation with a September 30, year end. For ten years RCC constructed special-purpose buildings and reported revenues on the percentage-of-completion method.
John also owns Construction Equipment, Inc. (CE). CE is a calendar year S corporation that rents and leases construction equipment to contractors. Typically 25% of CE's revenue have been from RCC. CE uses the accrual basis of accounting.
On September 30th of Year 10, RCC's tax-basis balance sheet:
Assets
Current Assets
Cash $2,502,826
Certificates of deposit 125,949
Investment Securities 2,197,287
Accounts receivable net 254,250
Prepaid expenses & other current assets 26,100
Total Current Assets 5,106,412
Property & Equipment $1,262,732
Less: Accumulated Deprec. 723,496
539,236
$5,645,648
Liabilities & Stockholder's Equity
Current Liabilities
Accounts Payable $819,390
Accrued expenses 172,066
Total Current Liabilities $991,456
Stockholder's Equity
Common stock 500
Paid-in capital 77,413
Retained earnings 4,576,279
$5,645,648
The fair market value of the investment securities is about $4 million. The value of the equipment is about $2 million. In the past, RCC has maintained, for purposes of the Accumulated Earnings Tax that it needs a reserve of at least $ 4 million dollars to prepare for the purchase of new equipment.
On December 31 of Year 10, Construction Equipment's tax-basis balance sheet showed:
Assets
Current Assets
Cash $1,397,848
Accounts receivable net 525,000
Total Current Assets 1,922,848
Property & Equipment $1,385,984
Less: Accumulated Deprec. -423,439
962,545
$2,885,393
Liabilities & Stockholder's Equity
Current Liabilities
Accounts Payable $86,982
Accrued expenses 2,091
Total Current Liabilities $89,073
Stockholder's Equity
Common stock 500
Paid-in capital 25,893
Retained earnings 2,769,927
$2,885,393
The equipment of this company has a FMV of about $800,000.
Situation
In February, Mr. Ralph sold all the fixed assets owned by both companies to an unrelated third party for FMV and moved to Alaska. He doesn't know what he should do with either company now.
1. Explain the issues Mr. Ralph and his companies would face if he did nothing and continued to hold the remaining assets where they are.
2. Explain the tax ramifications to both Mr. Ralph and his companies if he were to liquidate both companies immediately.
3. Suggest two alternative courses of action. Explain why these options are better than doing nothing or liquidating immediately. Evaluate the pros and cons of each suggestion.
4. Provide at least one example of an estate planning issue that might make it more beneficial to liquidate the companies at some point.
5. Make a final recommendation.
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Solution Summary
In a 2400 word solution, the response is very detailed in the application of tax law. Code Sections are cited frequently to explain complex tax concepts regarding corporations under Sub chapter C and S. There are calculations and comparison to demonstrate various options about built in gains and accumulated earnings tax in liquidation and more.
Solution Preview
First, let us examine the relevant tax law issues.
What are the disadvantages that RCC faces? A significant disadvantage is double taxation. By the time the shareholders receive their after-tax shares of the profits, there will have been two levels of tax - a tax on the corporation and a tax on the dividends. For this reason, many people choose a different entity - such as an S corporation or a partnership.
You are requested to think in the following terms: Another disadvantage is that liquidation or sale of the corporate assets will also result in double taxation to the shareholders, if there is any taxable gain.
You may consider the following: C Corporations are also less flexible than partnerships when it comes to special allocations of profits or expense items.
Losses stay in the corporation and cannot be passed through to the shareholders.
You are encouraged to think in these terms: An S Corporation avoids the double taxation that faces C corporations. Profits are "passed through" to the shareholders without being taxed in the corporation.
Losses are also passed through to the shareholder, unlike in a C corporation. But there are limitations on how much loss can be taken by a shareholder.
You are encouraged to reflect on these: It is less flexible than partnerships regarding allocations of profits and expenses. Liquidation can result in taxable gain to the shareholders.
Present law contains several provisions relating to the treatment of S corporations as corporations generally for purposes of the Internal Revenue Code.
First, under present law, the taxable income of an S corporation is computed in the same manner as in the case of an individual (sec. 1363(b)). Kindly consider this: Under this rule, the provisions of the Code governing the computation of taxable income which are applicable only to corporations, such as the dividends received deduction, do not apply to S corporations.
Second, except as otherwise provided by the Internal Revenue Code and except to the extent inconsistent with subchapter S, subchapter C (i.e., the rules relating to corporate distributions and adjustments) applies to an S corporation and its shareholders (sec. 1371(a)(1)). It is important to think of the problem in these terms: Under this second rule, provisions such as the corporate reorganization provisions apply to S corporations. Thus, a C corporation may merge into an S corporation tax-free.
Finally, an S corporation in its capacity as a shareholder of another corporation is treated as an individual for purposes of subchapter C (sec. 1371(a)(2)). Please consider these facts: In 1988, the IRS took the position that this rule prevents the tax-free liquidation of a C corporation into an S corporation because a C corporation cannot liquidate tax-free when owned by an individual shareholder.63
In 1992, the IRS reversed its position, stating that the prior ruling was incorrect.64
The Committee wishes to clarify that the position taken by the IRS in 1992 that allows the tax-free liquidation of a C corporation into an S corporation represents the proper policy.
The provision repeals the rule that treats an S corporation in its capacity as a shareholder of another corporation as an individual. Thus, the provision clarifies that the liquidation of a C corporation into an S corporation will be governed by the generally applicable subchapter C rules, including the provisions of sections 332 and 337 allowing the tax-free liquidation of a corporation into its parent corporation. You are requested to think in the ...
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