Question

Problem 18-27 (LO. 1, 3)

Tom and Gail form Owl Corporation with the following consideration:

Consideration Transferred Basis to Transferor Fair Market Value Number of Shares Issued From Tom— Cash $50,000 $50,000 Installment note 240,000 350,000 40 From Gail— Inventory 60,000 50,000 Equipment 125,000 250,000 Patentable invention 15,000 300,000 60

The installment note has a face amount of $350,000 and was acquired last year from the sale of land held for investment purposes (adjusted basis of $240,000). Regarding these transactions, provide the following information:

If an amount is zero, enter "0".

a. Tom's recognized gain or loss is $_____________.

b. Tom's basis in the Owl Corporation stock is $______________.

c. Owl Corporation's basis in the installment note is $________________.

d. Gail's recognized gain or loss is $_______________.

e. Gail's basis in the Owl Corporation stock is $_________________.

f. Owl Corporation's basis in the inventory is $______________ and equipment is $______________. Its basis in the patentable invention is $.

g. Would your answers to the preceding questions change if Tom received common stock and Gail received preferred stock?
______________(YES/NO), because there ____________ (IS A/IS NOT) requirement that the transferors receive the same type of stock.

h. Would your answers change if Gail was a partnership instead of an individual?
_____________(YES/NO), because there ____________(IS A /IS NOT) requirement that the transferors be individuals.

i. Gail is considering an alternative to the plan as presented above. She is considering selling the inventory to an unrelated third party for $50,000 in the current year instead of contributing it to Owl. After the sale, she will transfer the $50,000 sales proceeds along with the equipment and patentable invention to Owl for 60 shares of Owl stock. Whether or not she pursues the alternative, she plans to sell her Owl stock in six years for an anticipated sales price of $700,000. In present value terms and assuming she later sells her Owl stock, determine the tax cost of (1) contributing the property as originally planned, or (2) pursuing the alternative she has identified.

Assume a discount rate of 6%. The present value factors at 6% are 1.000 for year 1 and 0.7050 for year 5. Further, assume Gail's marginal income tax rate is 28% and her capital gains rate is 15%.

If required, round your answers to the nearest dollar.

Tax cost associated with sale of Owl stock for $700,000 is $_______________. Tax cost associated with the current sale of inventory for $50,000 and subsequent sale of Owl stock for $700,000 is $________________. The present value of the tax cost of the alternative is
$_______________.

Answer 1

a. Tom's recognized gain or loss is $ 0

This transfer meets the requirement of Sec 351. Hence, Tom doesn't recognize any gain or loss.

b. Tom's basis in the Owl Corporation stock is $ 290,000.

Tom’s Basis = Cash + Installment Note = $50,000 + $240,000 = $290,000

c. Owl Corporation's basis in the installment note is $ 240,000.

d. Gail's recognized gain or loss is $ 0.

This transfer meets the requirement of Sec 351. Hence, Gail doesn't recognize any gain or loss, either.

e. Gail's basis in the Owl Corporation stock is $ 200,000.

Gail's basis = Inventory + Equipment + Patentable Invention = $60,000 + $125,000 + $15,000 = $200,000

f. Owl Corporation's basis in the inventory is $ 60,000 and equipment is $ 125,000. Its basis in the patentable invention is $ 15,000

g. Would your answers to the preceding questions change if Tom received common stock and Gail received preferred stock?
NO, because there IS NOT requirement that the transferors receive the same type of stock.

h. Would your answers change if Gail was a partnership instead of an individual?
NO, because there IS NOT requirement that the transferors be individuals.

i. Tax cost associated with sale of Owl stock for $700,000 is $ 75,000

Tax cost = (Amount realized - Basis of Owl stock) x Tax rate = (700,000 - 200,000) x 15% = $ 75,000

And the present value is 75,000 x PV factor for year 5 = 75,000 x 0.7050 = $ 52,875

Tax cost associated with the current sale of inventory for $50,000 and subsequent sale of Owl stock for $700,000 is $ 73,700.

Tax cost of Current sale of inventory = (Sale value - Basis) x tax rate = (50,000 - 60,000) x 28% = -2,800

Tax cost of Subsequent sale of Owl stock = (Sale Value - Basis) x tax rate = (700,000 - 190,000) x 15% = 76,500

Hence, total tax cost = - 2,800 + 76,500 = 73,700

The present value of the tax cost of the alternative is $ 51,133

The same has been arrived at as = - 2,800 x PV factor for year 1 + 76,500 x PV factor for year 5 = - 2,800 x 1 + 76,500 x 0.7050 = $  51,133