CENTRAL COLORADO LEASING, INC.

CENTRAL COLORADO LEASING, INC.

CENTRAL COLORADO LEASING, INC.

Subject: Business    / General Business
Question

Central Colorado Leasing, Inc. (Central), a calendar year, accrual basis C corporation, is in the business of leasing heavy construction equipment and subcontracting certain types of heavy construction services.

CENTRAL COLORADO LEASING, INC.
Central Colorado Leasing, Inc. (Central), a calendar year, accrual basis C corporation, is in the business of leasing heavy construction equipment and subcontracting certain types of heavy construction services. The average rental period for the equipment is two weeks, and the rental contracts provide that Central will perform all required maintenance and repair for the equipment during the rental period. Brothers Jonathan and James Black each own 50 percent of the outstanding stock of Central. Jonathan is the president of the corporation and James is the vice-president. Currently, the Black brothers have no interest in making an S election for their corporation. Attached are Central’s financial statements for the current year.

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.jpg”>Jonathan Black is involved in a number of successful business ventures, and he estimates that his adjusted gross income for Federal tax purposes will fall in the $375,000 – $425,000 range for the next several years. Jonathan brings a $200,000 capital loss carryover and a $175,000 passive activity loss (PAL) carryover into the current year.

Jonathan owns Bishops Woods, a commercial office building and complex. His acquisition cost for Bishops was $2,750,000; $500,000 of this cost was allocated to the land. Through the beginning of this year, Jonathan has deducted $377,438 of depreciation on the property. Because of a low occupancy rate, the operation of Bishops has been generating net tax losses for several years ($50,000 of Jonathan’s PAL carryover is allocable to the office building).

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To generate a sizeable §1231/capital gain and use the loss carryforward, Jonathan is considering selling Bishops Woods to Central. Central then will move its administrative operations into the vacant office space upon expiration of its present lease in June.

Although Jonathan has not obtained an independent appraisal of Bishops Woods, he and James have agreed informally to a total purchase price of $3.25 million. Central will borrow this amount from an unrelated commercial lender, at market interest rates. The property forms the collateral on the debt.

II

Jonathan Black, James Black, James’ three adult children, and two adult grandchildren are considering the creation of CC Asphalt, a new corporate venture through which to operate an asphalt paving business. The seven individuals anticipate capitalizing the corporation so as to become equal shareholders. The Black brothers have projected that the business will generate net income before taxes of approximately $80,000 per year. The family members have agreed upon a strategy to reinvest the after-tax corporate income in the business, with the expectation of selling their corporate stock at a substantial profit at a future date.

To finance his capital contribution to CC Asphalt, James plans to borrow $250,000 in cash from Central. The note will be a properly drafted 1.0 percent demand note, when the market rate of interest for such loans is 2.5 percent. Jonathan Black has agreed to these terms for the proposed loan to his brother.

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Jonathan and James have requested that you identify any potential tax problems or planning ideas suggested by the facts presented. In responding to the Black brothers’ request, be as specific as possible in describing the issues involved, and provide suggestions and/or alternatives you recommend to minimize risks and maximize opportunities.

Central Colorado Leasing, Inc
Book Balance Sheet

December 31

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Notes

1. Company policy requires that customers make weekly payment on equipment rentals; therefore receivable balances generally are low.

2. Accrued expenses include a $25,000 year-end bonus payable to President Jonathan Black.

3. Jonathan and James Black both drive cars furnished to them by Central. The two brothers use the cars both for commuting and business reasons.

Central Colorado Leasing, Inc

Book Income Statement

Year Ending December 31

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Notes

1. Officers’ salaries: Jonathan Black $150,000 (includes $25,000 accrued bonus); James Black $100,000.

2. Because of the small corporation exemption [§ 55(e)], Central is not liable for the alternative minimum tax.

Your client, Frank Bearden, owns an Arkansas business that brokers high-quality fresh fruits and vegetables to restaurants and specialty grocery stores

BEARDEN’S SPECIALTY PRODUCE, INC.
Your client, Frank Bearden, owns an Arkansas business that brokers high-quality fresh fruits and vegetables to restaurants and specialty grocery stores. Frank’s business does not carry any inventories. Frank’s attorney has urged Frank to incorporate the business, primarily because of the limited shareholder liability associated with corporate status, and to facilitate a business succession plan in the future. Frank has operated the business as a cash basis sole proprietorship for two decades, and anticipates incorporating the business on July 1 of the current year. Projected balance sheet and income statements for the business as of June 30 are attached.

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.jpg”>Frank plans to transfer all existing business assets and liabilities to a newly incorporated entity, Bearden’s Specialty Produce, Inc. (Produce), in exchange for 1,000 shares of voting common stock. He will serve as President of the corporation, and he will be a member of the Board of Directors. Frank wants to adopt an August 31 fiscal year end for Produce because August tends to be the slowest month of the year for the business, and accounts receivable typically are at their lowest level. Frank also intends for Produce to continue to use the cash method of accounting.

Frank’s close friend, Maria Garcia, has for some time been interested in buying into Frank’s business. Maria will not have access to the cash necessary for this acquisition until October, so Frank has agreed to proceed with the incorporation, and then sell 400 of his new Produce shares for $75,000 to Maria sometime before the end of the current year.

In discussing the proposed incorporation with you, Frank specifically asks about the amount of any gain he must recognize, both upon the incorporation itself, and upon the subsequent stock sale. Naturally, he is eager to minimize any recognized gain to the extent possible. Frank also wants to structure the transaction to achieve the best tax outcome for Garcia, as Frank is eager to have her as a business associate.

In addition to addressing these specific concerns, identify any potential tax problems or planning ideas suggested by the facts. Be specific in describing the issues involved, give full citations to controlling law, and provide suggestions and/or alternatives to minimize risks and maximize opportunities.

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II

Elsewhere in his portfolio, Frank is a limited partner in Build Arkansas, a real estate development partnership. Build has generated losses during the past two years. Frank holds a $35,000 suspended passive loss. Frank earns no passive activity income, and he anticipates that the partnership will continue to generate losses for several years into the future. He has asked you to explain the §469 tax consequences of transferring his interest in Build to Produce as part of the incorporation. The value of the partnership interest exceeds Frank’s basis in the interest by approximately $50,000.

Bearden’s Specialty Produce

Projected Balance Sheet

June 30

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Bearden’s Specialty Produce

Projected Income Statement

For January 1 – June 30

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* Legal costs for drafting the corporate charter and by-laws and for filing the necessary legal papers with Arkansas will total $7,000. Frank estimates that Produce will incur accounting fees attributable to the incorporation of $5,200.

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