Instructions:
You as a seasoned tax professional are hired by a large publicly traded company in Silicon Valley to perform a due diligence study on a relatively young startup, ABC Inc. (“ABC”) that has a great potential for its unique high-tech product. The interest has been expressed for possible takeover of ABC. Your task is to put together a due diligence report for the potential purchaser. The final board approval of the buyout depends on the merit of the underlying operations of ABC, so your analyses on the report are utterly important.
The format of your due diligence report should be research-like technical analysis report with facts and issues (as Questions here) already provided to you. The Law and Analysis section should first list out all applicable laws followed by detailed analyses which need to be substantiated by the computations and schedule (should be separately attached as Exhibits). The computations should be based on the facts in accordance with applicable laws, and use explicitly listed-out reasonable assumptions if only necessary.
Requirement:
You are required for detailed tax analysis based on the information available to you. You analysis must:
(1) Address the issues and questions listed in the section below,
(2) Apply applicable laws to the facts,
(3) List out and explain all the potential risks that could harm the potential purchaser, and
(4) Lastly, please prepare a schedule showing the reconciliation form book to tax, which should approximate the actual US federal taxable income for the year ending December 31, 2015( no annualization is required).
Background Facts
On January 1, 2012, a high technology product maker, ABC Inc. (“ABC”) was incorporated in the state of California. The initial shareholders were the three equal-partners of a limited liability company (A, B and C) who decided to form a C corporation for better developing their proprietary product and operating their trade and business in the most efficient manner. The three initial shareholders are also the key officers of the company, hoping one day to bring the company public.
In setting up ABC, the three initial shareholders contributed some cash, properties and patent, as follow, into the newly established company in exchange for 100% of ABC stock.
Shareholder A put in a piece of land he bought some time ago with the FMV of $200,000 (adjusted basis is $40,000), subject to a mortgage of $30,000 at the time of the company’s formation. Shareholder B contributed cash of $170,000. Shareholder C who is a technical person did not want to commit any money but transferred his patent to ABC instead. He agreed to be in charge of the company’s technology development and perform all the necessary services to the company. His service is very valuable and was worth at least $150,000 at the time of the contribution. Additionally, his patent was valued at $20,000.
ABC issued 15,000,000 shares of common stock at the par value of $0.01 each to the initial shareholders along with the return of $30,000 cash and $90,000 other property.
ABC is a high technology product maker with a relative low gross margin. The company’s top management (mainly consisting of the initial shareholders) is a true believer of products “Made in U.S.A.” ABC develops and manufactures all the components of the product as well as assembles the product at a facility in the Bay Area, California. Although the high cost of the rent, labor, which erodes its margin, the management is proud of being patriotic (the patriotism should be qualified for “domestic production activity deduction” put out as an incentive by the US government.)
A year later, ABC ran into a financial trouble of cash flow. The company was unable to collect accounts receivable fast enough (60-day policy with more than half of the invoices not collected past 120 days) to support its continuous operation. The management’s lack of attention to the trade account management had resulted in the account receivables being piled up. The company was experiencing severe cash shortage for raw materials and employees’ salaries. Employees had not been paid for over months, and the company’s moral was also a huge headache for the HR department.
ABC management assessed the situation and determined that the company needed $5 million to keep the operation afloat. The finance department worked with outside advisors to decide the best way to raise the fund without giving up the control or meaningful ownership. The Company was widely considered a fine candidate in the industry for the NASDAQ listing, and its product was the second to none in the market.
The ABC outside financial advisors recommended raising the fund through financial markets. The advisory and the underwriting fee could be as high as 50%. In order to prevent from giving up the control and the perceived low demand for its common stock, the deal was structured as a corporate bond sale in the secondary market for most of the financing and private stock placement for the remaining.
ABC Issued the corporate bond with a term of 10 years, 10% interest rate, with the yield to maturity of 11% compounding semiannually. It pays a qualified stated interest of $100,000 and has a redemption price at the maturity of $4,400,000. The bond was sold for $4,000,000 on May 1, 2013. The remaining was financed with the company’s new issuance of additional 1,000,000 shares ($1.00 per share) of common stock to those who were willing to bet on company’s future prospects.
Soon after ABC raised $5 million, ABC fulfilled its operation to its ultimate and developed its state-of-art first class high-tech product which was in tremendously high demand. Sales had skyrocketed, and the profit had mushroomed since the end of 2013. In 2014, ABC dramatically improved its financial position with sales revenue $50,000,000. ABC also invested in another company that develops the technology badly needed by ABC, with roughly 45% of ownership in the company.
With this success, the top management wanted to express their gratitude to those shareholders who were willing to believe in them and bought the shares in those darkest days. It was decided that ABC will declare and pay the first ever dividend to all of its shareholders at $2.00 per share, and additional one share of common stock (valued at $2.00 per share) for every two shares held by the shareholders on the record on December 31, 2014. Both cash and common stock dividends will be paid on July 1, 2015. Some of shareholders immediately afterwards sold the distributed shares to other institutional investors $5.00 a share.
Question 1
Whether does the ABC formation qualify for §351 tax free treatment? Apply applicable laws to your analysis, and explain factors that may be considered for such qualification and potential risks the shareholders and ABC might face.
Question 2
Assuming the ABC formation qualifies for §351 tax free treatment, identify and calculate any gain or loss to be realized and recognized for each shareholder. List out calculation steps clearly and discuss the results by applying applicable laws.
Question 3
If Shareholders A decides to terminate his entire interest afterwards in ABC and sells his shares at $.05 per share, what is the amount of gain the Shareholder A would recognize if any. Discuss the result by applying applicable laws, and explain any possible impacts on Shareholders B, C and ABC.
Question 4
Analyzing ABC’s financing strategy with pros and cons of each alternative of financing. Please be specific as much as possible, such as corporation’s preference of one over another and the possible consequences that might face the equity vs. debt investors upon the corporate default, etc. Apply applicable laws to your analysis.
Question 5
ABC issued corporate bond and sold a small percentage of additional common shares to finance its business operation. Please discuss what the potential issues would be for the federal income tax purpose, such as debt to equity ratio, COD income, etc. If the debt is issued as a discount, please compute the additional interest expense due to OID for the year where the bond was sold (assuming no leap year). Apply applicable laws to your analysis and computation.
Question 6
Upon the declaration of the dividends, please analyze the distributions, both cash and stock dividend based on applicable laws. Determine the amount of inclusion step by step within the framework of IRC §301, 316, 305 and 306. Apply applicable laws to your analysis and computation. Please refer to the attached 2015 trial balances for the computation if necessary.
Assumptions:
1. The prior year’s taxable income equal to the book income, and the prior year’s earnings and profits equal to the book retained earnings.
2. The current year’s earnings and profits equal to the current year taxable income.
Question 7
Use the information provided here and the data from the attached trial balances, prepare ABC’s 2015 federal income tax calculation on spreadsheet (please don’t run the numbers through any tax preparation software). Calculate step by step any limitation applicable to each category.
Assumptions:
1. There are no book-to-tax timing differences for accruals, reserves, depreciation and amortization, etc.
2. Domestic production gross receipt equals to the product sales and directly related service income.
3. Only cost of goods sold is counted for qualified production activity income purpose.
4. There are no AMT and ACE adjustments.
5. The Federal corporation income rate is 35%.
ABC Inc. Trial Balances (for the year ended 12.31.2015)
110000 Pretty cash-local currency 1,097
111000 Checking account 2,619,323
111020 YPP Depository 1,135,828
111070 Payroll Account 16,499
120012 Accounts receivable 1,854,167
122200 Security deposit 4,792
123000 Investment 3,600,000
150200 Prepayment 206,111
160020 Furniture and fixtures 17,873
160060 Computer hardware 214,542
160070 Computer software 13,383
170020 Accumulated depreciation-furniture (1,749)
170060 Accumulated depreciation-computer har (88,810)
170060 Accumulated depreciation-computer sof (4,600)
190000 Deposit-long term 66,219
192020 Other intangible Assets 5,200,000
193010 Accumulated amortization-licenses (5,095,000)
211010 Short term loan (4,500,000)
212000 Accounts payable-domestic (529,530)
212215 Accounts payable-related (485,714)
213215 Accounts payable-Japan (2,168,988)
213220 Accounts payable-Europe (711,006)
214520 VAT payable (34,093)
214902 State income tax payable (2,925)
215000 Accrued salaries (426,877)
215001 Accrued vacation expense (401,253)
215004 Accrued payroll taxes (43,974)
215005 Accrued dependent care 125 (4,886)
215006 Accrued health care 125 (3,520)
215011 Accrued 401K (20,795)
215012 Transportation Plan section 132 (18,579)
216160 Accrued promotions (8,524)
216181 Deferred Revenue (176,324)
216185 Deferred Rent (768)
216200 Accrued interest (10,767)
214902 State income tax payable 0
224000 Deferred Rent-Long Tern (386)
310000 Common stock (150,000)
320000 Additional paid in capital 0
330000 Retained earnings 1,500,000
440000 Product sale revenue (50,000,000)
440010 External service income (879,075)
450010 Dividend income (2,000,000)
450030 Mobile App revenue (75,850)
460000 Ad revenue (22,168)
470999 Royalties (270,020)
471000 Royalty income(foreign) (55,992)
480050 Other income (6,217)
561001 Cost of goods sold 36,000,000
561002 Raw materilas 5,000,000
561011 other COGS 433,210
610020 Media-online 167,061
610040 Media-Facebook ads 63,940
610120 Production-online 410,000
620060 Public relations-display materials 12,901
620070 PR-Email Marketing 240
620099 PR-miscellaneous 61,740
620101 PR-events 25,066
630099 Tradeshow-miscellaneous 350,000
640010 Merchandising-POP Display 756
640099 Merchandising-miscellaneous 557
650000 Qualitative research 9,300
660000 Promo-fulfillment 4,229
660010 Promo-production costs 39,495
660040 Promo-agency fees 20,000
701000 Salaries-base wages 4,044,583
701001 Salaries-overtime 3,169
701002 Bonus 552,044
701003 Vacation expense 65,057
701101 Employer payroll taxes 373,501
771103 Medical insurance 415,825
701104 Dental insurance 49,550
701105 Vision insurance 3,330
701106 Worker’s compensation 7,019
701107 Employeebenefit-life and disability 14,853
701108 Health club fees 0
701109 Emplyeebenefit-employee goodwill 9,890
701111 Meals and Entertainment 62,530
701112 SF business tax 55,523
702000 Consulting expense 321,467
702020 Payroll processing fee 17,039
703000 Recruiting fees 38,467
704000 Office supplies 22,902
704010 Office equipment 585
704020 office furniture 1,709
705000 Software 20,974
705010 Hardware 15,552
705040 Fixed assets below capitalization polic 10,992
706010 Auto rental 292
708040 Corporate ISP 201,755
709000 Dues & subscriptions 10,613
710010 Competitor samples 44
711020 Depreciation-furniture 1,215
711060 Depreciation-computer har 31,744
711070 Depreciation-computer sof 4,448
712000 Rent-facilities 556,064
713000 Utilities 34,819
713020 Janitorial 12,772
713040 Security 825
714010 Repair and maintenance-facilities 345
714020 Repair and maintenance-machinery & equip 671
714040 Repair and maintenance- other 198
715000 Insurance-commercial general 21,763
715002 Insurance-commercial umbrella 1,853
716000 Accounting and audit fees 38,612
717000 Legal fee 7,057
717020 Charitable contribution 50,000
718000 Property taxes 1,358
718010 Non-income taxes 3,365
718020 Tax penalties 622
720000 Other general expenses 88
800000 Bank charges 1,390
800300 interest expense-bond 400,000
800800 Miscellaneous 50,850
900000 Corporation income tax expense-federal 1,244,660
900001 Corporation income tax expense-State 366,077
Place this order with us and get 18% discount now! to earn your discount enter this code: special18 If you need assistance chat with us now by clicking the live chat button.