Outright Purchase of Smithon Stock

Week 6 You Decide

Whitney Lockman

1.Outright purchase of Smithon Stock

a. Should Mr. Jones purchase the stock of Smithon outright, leaving Smithon intact? By purchasing Smithon outright, Mr. Jones would acquire the corporations entire operations including its assets, liabilities, contractual obligations, and he would also be responsible for its day to day operating decisions. I would not recommend a purchase like this because Smithon will continue to recognize its current tax identity through this stock purchase. While this transfer of ownership would qualify as a tax free exchange under Code Sec. 351, the reality of the contractual obligations Mr. Jones could potentially deal with would not make this move a positive one.

Should Mr. Jones issue debt from Johnson Services Company to pay for the Smithon Company- would that raise debt to equity issues? Mr Jones stated that Johnson Services has recently had significant losses. By issuing stock to pay for the purchase of Smithon, the debt to income ratio of Johnson Services would be damaged and it may put the corporation in a position of being a high risk investment for potential investors or for financing reasons. For this reason I would say that Mr. Jones should not issue stock from Johnson Services to purchase Smithon Company.

b. Should Mr. Jones convert Smithon to an S Corporation and change the fiscal year end to a calendar year end? I think that it would be advisable for Mr. Jones to convert Smithon to an S Corporation because it would avoid double taxation issues. Since a C Corporation is charged taxes on their net income and then the dividends paid out are also charged taxes, there is a greater tax liability to retain the status of a C Corporation. If there are build up retained earnings in the C corporation, those retained earnings would be taxed as if they were dividend earnings at the time of distribution. (Code Sec. 1371(a).

The fiscal year end would have to be changed to a calendar year end because there is no other business reason to not have a calendar year end. According to Code Section 1378(b) there could be a required payment representing the tax break that would be incurred if the S Corp did not recognize the calendar year end without a proper business reason.

c. What potential income tax ramifications exist for Mr. Jones personally if he purchases the stock of Smithon and converts it to an S Corporation? If Mr. Jones purchases the stock of Smithon and converts it to an S Corporation, any income that is reported from the corporation is passed on to Mr. Jones as the stockholder and is taxed at his personal tax rates, which could