Accounting

Martha, a single individual, has come to you with a new business concept. She has created a unique type of glove that runners can use for taking their vitals while working out. The glove also sends runners alerts and automatically posts running information for them on social media websites. She has tested the gloves on various platforms and they not only worked but have garnered strong interest among her friends and colleagues. With this encouragement, Martha has decided to form a company to further develop and market her product. The business will be called “IN TOUCH.”

Martha understands that it will take time for the business to become profitable. She would like to grow her business and perhaps at some point go public or at some point sell the business to a large retailer.

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Martha decided to quit her full-time job so that she could focus all efforts on the new business. Martha had some savings to support herself for a while, but she did not have any other source of income. She was able to recruit Sarah and Amilcar to join her as initial equity investors in IN TOUCH. Sarah has an MBA and a law degree. Sarah was employed as a business consultant when she decided to leave that job and work with Martha and Amilcar. Sarah’s husband earns close to $300,000 a year as an engineer (employee).

Amilcar owns a very profitable used car business. Because buying and selling used cars takes all his time, he is interested in becoming only a passive IN TOUCH investor. He wanted to get in on the ground floor because he really likes the product and believes IN TOUCH will be wildly successful. While IN TOUCH originally has three investors, Martha and Sarah have plans to grow the business and seek more owners and capital in the future.

The three owners agreed that Martha would contribute land and cash for a 30 percent interest in IN TOUCH, Sarah would contribute services (legal and business advisory) for the first two years for a 30 percent interest, and Amilcar would contribute cash for a 40 percent interest. The plan called for Martha and Sarah to be actively involved in managing the business while Amilcar would not be an active manager.

The three equity owners’ contributions are summarized as follows:

Martha Contributed

FMV

Adjusted

Basis

Ownership

Interest

Land (held as investment)

$120,000

$70,000

30%

Cash

$30,000

Sarah Contributed

Services

$150,000

30%

Amilcar Contributed

Cash

$200,000

40%

Working together, Martha and Sarah made the following five-year income and loss projections for IN TOUCH. They anticipate the business will be profitable and that it will continue to grow after the first five years.

In Touch Software

5-Year Income and Loss Projections

Year

Income

(Loss)

1

($200,000)

2

($80,000)

3

($20,000)

4

$60,000

5

$180,000

To get the business activities started, Martha and Sarah determined IN TOUCH would need to borrow $800,000 to purchase a building to house its manufacturing facilities and its administrative offices (at least for now). Also, in need of additional cash, Martha and Sarah arranged to have IN TOUCH borrow $300,000 from a local bank and to borrow $200,000 cash from Amilcar. IN TOUCH would pay Amilcar a market rate of interest on the loan but there was no fixed date for principal repayment.

Martha is unsure where she wants to locate the business. She lives in D.C., but is considering Virginia, Maryland, and DC as possible business locations.

Required:

Provide a list of the significant tax and nontax issues, considerations and concerns that may differ across entity types (LLC taxed as a partnership, S corporation, Partnership, C corporation); and discuss how they are relevant to the choice of entity decision for IN TOUCH. You do not need to provide detailed computations for the business itself, but rather need only identify and provide a short description of the tax and non-tax issues in you list. Computations should be provided only if they are relevant to an issue (e.g., if a tax issue were to arise based on a particular taxpayer’s income level, the computation might be relevant, or if a transaction results in a gain to which you are referring in your answer you can compute the amount of the gain). However, the primary focus of this problem will be on issue identification. Consider this document that you could use at a meeting Martha to discuss her business plans.

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