ACCT 366 Lecture 3: More answers to chapter 6
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Several years ago, your client, Brooks Robinson, started an office cleaning service. His business was very successful, owing much to his legacy as the greatest defensive third baseman in major league history and his nickname, “The Human Vacuum Cleaner.” Brooks operated his business as a sole proprietorship and used the cash method of accounting. Brooks was advised by his attorney that it is too risky to operate his business as a sole proprietorship and that he should incorporate to limit his liability. Brooks has come to you for advice on the tax implications of incorporation. His balance sheet is presented below. Under the terms of the incorporation, Brooks would transfer the assets to the corporation in return for 100 percent of the company’s common stock. The corporation would also assume the company’s liabilities (payables and mortgage). (Negative amounts should be indicated by a minus sign. Leave no answer blank. Enter zero if applicable.)
Balance Sheet | |||||
Adjusted Basis | FMV | ||||
Assets | |||||
Accounts receivable | $ | 0 | $ | 5,000 | |
Cleaning equipment (net) | 25,000 | 20,000 | |||
Building | 50,000 | 75,000 | |||
Land | 25,000 | 50,000 | |||
Total assets | $ | 100,000 | $ | 150,000 | |
Liabilities | |||||
Accounts payable | $ | 0 | $ | 10,000 | |
Salaries payable | 0 | 5,000 | |||
Mortgage on land and building | 35,000 | 35,000 | |||
Total liabilities | $ | 35,000 | $ | 50,000 | |
a. How much gain or loss does Brooks realize on the transfer of each asset to the corporation?
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b. How much, if any, gain or loss (on a per asset basis) does Brooks recognize?
Realized gain/loss | |
Accounts receivable | |
Equipment | |
Building | |
Land | |
Total | $0 |
c. How much gain or loss, if any, must the corporation recognize on the receipt of the assets of the sole proprietorship in exchange for the corporation’s stock?
Gain or loss recognized -
d. What tax basis does Brooks have in the corporation’s stock?
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e. What is the corporation’s tax basis in each asset it receives from Brooks?
Tax Basis | |
Accounts Receivable | |
Equipment | |
Building | |
Land | |
Total |
f. How much if any gain or loss will Brooks recognize if he had taken back a 10-year note worth $25,000 plus stock worth $75,000 plus the liability assumption? (Do not round intermediate calculations. Round your final answers to the nearest whole dollar amount.)
Realized gain/loss | |
Accounts receivable | |
Equipment | |
Building | |
Land | |
Total | $0 |
Rex and Felix are the sole shareholders of the Dogs and CatsCorporation (DCC). After several years of operations using theaccrual method, they decided to liquidate the corporation andoperate the business as a partnership. Rex and Felix hired a lawyerto draw up the legal papers to dissolve the corporation, but theyneed some tax advice from you, their trusted accountant. They arehoping you will find a way for them to liquidate the corporationwhile minimizing their total income tax liability.
Rex has a tax basis in his shares of $72,000 and Felix has a taxbasis in his shares of $36,000. The DCC’s tax accounting balancesheet at the date of liquidation is as follows: (Negativeamounts should be indicated by a minus sign. Leave no answer blank.Enter zero if applicable.) Corporate tax rate
Adjusted Basis | FMV | ||||
Assets | |||||
Cash | $ | 34,000 | $ | 34,000 | |
Accounts receivable | 11,000 | 11,000 | |||
Inventory | 11,000 | 22,000 | |||
Equipment | 34,000 | 22,000 | |||
Building | 17,000 | 34,000 | |||
Land | 13,000 | 50,000 | |||
Total assets | $ | 120,000 | $ | 173,000 | |
Liabilities | |||||
Accounts payable | $ | 5,000 | |||
Mortgage payable—Building | 7,500 | ||||
Mortgage payable—Land | 7,500 | ||||
Total liabilities | $ | 20,000 | |||
Shareholders’Equity | |||||
Common stock—Rex (80%) | $ | 72,000 | $ | 118,000 | |
Common stock—Felix (20%) | 36,000 | 35,000 | |||
Total shareholders equity | $ | 108,000 | $ | 153,000 | |
Required:
A. Compute the gain or loss recognized by Rex,Felix, and DCC on a complete liquidation of the corporationassuming each shareholder receives a pro rata distribution of thecorporation’s assets and assumes a pro rata amount of theliabilities.
B. Compute the gain or loss recognized by Rex,Felix, and DCC on a complete liquidation of the corporationassuming Felix receives $35,000 in cash and Rex receives theremainder of the assets and assumes all of the liabilities.
For parts c and d: Assume Felix received the accounts receivableand equipment and assumed the accounts payable.
C. Will Felix recognize any income when hecollects the accounts receivable?
D. Will Felix be able to take a deduction whenhe pays the accounts payable?
For parts e and f: Assume Rex is a corporate shareholder ofDCC.
E. Compute the gain or loss recognized by Rex,Felix, and DCC on a complete liquidation of the corporationassuming each shareholder receives a pro rata distribution of thecorporation’s assets and assumes a pro rata amount of theliabilities.
F. Compute the gain or loss recognized by Rex,Felix, and DCC on a complete liquidation of the corporationassuming Felix receives $36,000 in cash and Rex receives theremainder of the assets and assumes all of the liabilities.