Question

  VAN HORN INDUSTRIES

Reggie, Sarah, Theo, and Ursula Van Horn incorporated a new business in 2012; Van Horn Industries was formed as a calendar-year Missouri C corporation with a contribution of land and a large building by Reggie, and cash from the other three shareholders. Reggie and Sarah are married to each other, and Theo and Ursula are their single adult children. Reggie and Sarah are full-time shareholder-employees, while Theo, a dentist, and Ursula, an engineer, are investors only. The family members get along well, and no ownership or operating changes are planned for the foreseeable future. The company’s offices and operations are based in a single building near Sunset Hills MO.

                Reggie and Sarah file joint income tax returns, and Theo and Ursula file as single. Theo operates his dental practice through a national chain (The Smile Superstore) that pays him a $125,000 salary. Ursula is employed by a consulting firm that specializes in roads and bridges; her annual salary is $145,000. There are no other sources of gross income during the period of this analysis for any of the Van Horns.

Industries pays 60 percent of its C taxable income as salaries to Reggie (60%) and Sarah (40%). The remaining taxable income is distributed as cash dividends to the four shareholders.

As a C corporation, Van Horn Industries pays a flat 34 percent federal corporate income tax. For 2016, Theo and Ursula are subject to a 28 percent marginal income tax rate; Reggie and Sarah are in the 33 percent bracket. Use the 2016 tax rates for the entire period of Industries’ life, regardless of inflation adjustments and other law changes.

Van Horn Industries offers logistical services to Amazon, the US Postal Service, AutoCare, a mobile car and truck maintenance service, and AnimalHelpers, a mobile veterinary and first-aid service for pets that live in suburban residences. Industries has stayed ahead of the curve in providing logistical, planning, and

online recordkeeping for its clients, and the business has proven to be virtually “recession proof.” Prospects for the company in the next decade appear bright at this point: the company is to go-to provider of its services in a contiguous five-state area.

The company has received takeover offers from unrelated competitors over the years, especially from those who provide similar services to WalMart. But Reggie and Sarah are not interesting in retiring for many years, and all of the family members are happy with the mix of hands-on and hands-off owners that Industries has been using. The company is on good terms with the union that represents its drivers, and Industries has found a good mix of full-time and part-time drivers to carry out its contracts. An office group of about ten employees are paid slightly below market wages, but a good fringe benefit package means that the company’s steady growth has been supported at each stage by its workforce.

With a steady record of profits and the future bright, the Van Horns have become uncomfortable with the amount of income taxes that they are paying, i.e., combining the corporate income tax with their own individual taxes paid. Based on advice from their CPA, Julee Woods, they would like to know whether to convert the C corporation to an LLC, so as to eliminate the double taxation that they perceive exists in their case. The date of the proposed conversion is January 1, 2017. Today it is June 25, 2016.

You have been engaged to work with CPA Woods to provide information about the tax results of the proposed structural conversion. Your review of the corporate books and records finds that the needed information is complete and accurate as prepared by Industries. It includes the following items.

I

Provide a series of tables that will allow a comparison of the after-tax costs and benefits of a conversion to LLC status on the upcoming January 1. Ignore state and local income taxes and any AMT effects.

On the last day of the tax year before the conversion, Industries will transfer all of its assets and liabilities to the new LLC. For federal income tax purposes, these events will be treated as a deemed distribution, whereunder the entity sells off its assets at full FMV and distributes the net cash proceeds to the shareholders in exchange for their shares. The shareholders then contribute cash to the LLC in exchange for interests therein, and the new entity uses the cash to purchase all of the net assets of the prior C corporation.

II

CPA Woods has told you that the elder Van Horns are planning to operate the company for ten years after the C-to-LLC conversion. Because the children likely then will not be interested in carrying on the business as owners, the assumption is that Industries will be liquidated at that time. Add the consequences of this final, actual liquidation to your analysis.

Van horn industries

Financial records, and other pertinent assumptions

As of June 25, Prior to the C to LLC conversion

Shares owned    Shares of annual      Shares of annual          Basis in Van    Federal

                                                                Salaries paid             income after salaries     horn stock      income

                                                                                                     Paid as dividends                                        tax

Reggie                    40%                    60%                                     40%                        2,000,000          33%

Sarah                      30%                   40%                                          30%                        1,500,000          33%

Theo                        10%                                                                        10%                       500,000              28%

Ursula                     20%                                                                   20%                       1,000,000         28%

Last C year, taxable income after salaries and payroll taxes           400,000

First LLC year, taxable income before salaries                                   650,000

LLC year 2-10, annual increase in entity taxable income                 15%

Share of C, LLC taxable income paid as deductible salaries            60%

Annual after tax internal rate of return, Van Horn Industries       5%

Annual increase in Social Security wage base                                   1%

2016 Social Security wage base                                                           118,500

Social Security tax rate, ”both halves”                                               12.4%

Standard Medicare tax rate, “both halves”                                       2.9%

Additional Medicare tax rate on individuals                                     0.9%

Years from incorporation to conversion             5                                  

Years from conservation to liquidation               10

Within three months of incorporation, the following items were in place, and they do not change from year to year.

Cash                                                  230,000

Receivables                                     198,000

Goodwill                                           0

Operating payables                     100,000

Mortgage, Land and Building     1,000,000

At the same time, Industries had acquired and placed in service the following items. Specific rates of annual price appreciation/decline are indicated. All cost recovery is computed using straight-line assumptions.

                                                MACRS life          Initial Tax basis          Annual FMV increase

                                                                                                                      (decrease)

Inventory                                                            150,000                                 1.0%

Equipment                          7                              850,000                                 -5.0%

Office furniture                 7                              300,000                                 -5.0%

Land                                                                      1,700,000                             7.0%

Building                                39                           3,000,000                             2.0%

Answer 1

Most important rationale behind converting a C Corporation into an LLC is avoiding double taxation effects when the owners of the corporation want to switch to tax exempt distributions of business profits. Besides, there are other reasons also, namely avoiding potentially higher future tax rates, lowering down the conversion costs and last but not the least creation of limited liability unlike in a C Corporation.

At the time of conversion, one needs to bear in mind the tax effects of such an event. The conversion is only going to be successful when it brings the tax savings in future aligned with the present tax structure. Generally the cost of conversion is high and therefore, the shareholders of the corporation is looking forward to avail higher cost recovery deductions in the earlier years of conversion along with reduced amount of income taxes on profits.

The efforts must be made as: - 1. PV of the tax savings should outweigh the value of the current cost of conversion and recurring cost of taxation. State, Federal, Local etc. all types of taxes must be considered. Conversion costs also include consulting fees, stamp duties, taxes on liquidation etc.