RE: Memorandum
1(a). Should Mr. Jones purchase the stock of Smith outright, leaving Smithon intact? What about issuing debt in his Johnson Services company to pay for the Smith Company – would that raise debt to equity issues?
I would not suggest Mr. Jones to purchase the stock of Smith outright. a stock purchase has no effect on the tax basis of the Company’s assets. Instead, he will be taking a stepped up basis in the stock purchased equal to the amount he pays for the stock, and the taxable income inherent in the Company’s assets remains inherent in the assets.
Johnsons Services is already showing losses. While issuing debts in JS may give a rise to debt to equity ratio, the company should be careful in considering equity financing not to trigger an ownership change under Section 382 which may lead to limitations of using NOLs. Also, with even higher liabilities, it may be difficult to meet the debt service agreements if the company doesn’t have enough cash flow from operations.
1(c) What potential income tax ramifications exist for Mr. Johnson personally if he purchases the stock of Smithon and converts it to an S corporation? If the Mr.Jones decides to convert Smithon to a subchapter S Corporation, it will enable the corporation itself to avoid paying taxes, but the profit and losses will be passed to shareholders as personal income and losses.
Now we should consider the expected losses from the huge investment in equipment purchase. Net operating losses cannot be used to shelter personal income but can be carried forward by a C corporation to provide tax benefit in future when the business expects profit. Apparently, Mr. Jones is already in the top tax bracket. S-Corporation income tends to support start-up businesses and taxpayers with little income, because the corporation is taxed at the individual's lower personal income tax rate. The initial