Mimi’s Cupcakes Prompt Your business tax client, Mimi Charpentier, operates a successful sole proprietorship that sells cupcakes to retail customers at three locations in Las Vegas. Mimi’s Cupcakes does not carry any inventories because of the nature of its products. She owns the three small buildings in which the shops exist. One of the stores […]
Your business tax client, Mimi Charpentier, operates a successful sole proprietorship that sells cupcakes to retail customers at three locations in Las Vegas. Mimi’s Cupcakes does not carry any inventories because of the nature of its products. She owns the three small buildings in which the shops exist. One of the stores is slightly larger than the others; it is the owner's original location, and it still is the site of the kitchen and the loading dock where the Cupcakes trucks daily pick up and deliver merchandise and supplies.
The workforce of each store is the equivalent of 2.5 employees; the employees are paid reasonably well, and the low-pressure atmosphere of the typical workday results in a very low turnover rate. She offers only one fringe benefit to the employees – it encourages them to use Health Savings Accounts for their medical costs, and Mimi’s reimburses the employee for the out-of-pocket deductible amounts, to a $1,000 maximum per employee per calendar year.
[caption id="attachment_1273" align="alignnone" width="476"]Mimi's attorney, Gloria Willis, has urged her to incorporate the business, primarily because of the limited shareholder liability associated with corporate status, and to facilitate a business succession plan for the operation. After several years of discussions, The owner has agreed to go ahead with this idea. She will take a sixty percent ownership interest in the common stock of the new entity; twenty percent interest will be made available to her daughter Nancy and to Joan Price, the chief operating officer of the business, who is not related to the other two shareholders.
Mimi has operated the business as a cash basic sole proprietorship since 2004, and she anticipates incorporating the business on July 1 of the current year. The business's projected balance sheet as of June 30 is attached.
Willis’ practice consists of general work with small business clients. She is not by any means conversant with the federal income tax rules as they apply to individuals and C corporations. In this process, Willis is concentrating on the establishment of the new corporate entity, the retitling of assets as they are transferred from the proprietorship to the corporation, and the mechanics of creating and issuing shares to the new shareholders.
[caption id="attachment_1274" align="alignnone" width="450"]Mimi has come to you with various questions about how to set up her databases to prepare for the annual Form 1120 filings, including Schedule M-1. Corporate gross receipts will allow the continued use of the cash basis of tax accounting.
In your interviews with the three shareholders, you discover that the entrepreneur's life expectancy is about two years from the date of incorporation. Nancy recently graduated from a restaurant and hospitality management community college, emphasizing financial recordkeeping. Joan is about fifty years old, in good health, and planning to remain in charge of operating decisions for the three stores for the foreseeable future. Neither Mimi nor Joan projects that the corporation would add a fourth store, nor would it expand outside of Las Vegas, but the parties review these issues at least once a year.
The proprietorship does not carry any debt; its trade payables and receivables are disposed of promptly. Its website allows for remote ordering, scheduled pickups, and deliveries of larger orders to customer locations. She is active on Twitter and Facebook, where the company has about five thousand friends. This presence allows Mimi’s to plan and carry out “spontaneous” outdoor events on the stores’ patios, where high-markup products are made available in plentiful quantities.
[caption id="attachment_1275" align="alignnone" width="160"]As Mimi has told you several times, “this is a simple business, and we know how to keep our customers happy and coming back on a regular basis. I do not want the legal etc, aspects of an incorporation to disrupt the good thing that we have here.” But, in your dealings with Mimi over the years concerning her Forms 1040 and employment tax obligations, you know that she expects you to give her suggestions about how her tax liabilities would be affected by decisions that she makes and that she expects to “get it right the first time” when she makes her choices.
At Mimi’s latest appointment with her cardiologist, Cathy Duvall, MD, mentioned that her clinic was about to incorporate but that Duvall would retain her individual ownership of the clinic’s land and building. Duvall was certain that there were tax and legal advantages to structuring the corporation that way, but she could not explain those advantages to her.
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You will be meeting shortly with the business owner, Nancy, and Joan to discuss the tax aspects of the incorporation and to address any other of their concerns that are pertinent to your expertise.
Mimi certainly will ask you to cover the issue of which assets to contribute to the new corporation, with the explanations that Duvall could not provide. Concentrate on those issues for this meeting, offering at least two alternative plans for the asset transfers.
At the meeting, Nancy will look to you for information on issues of asset basis, as well as any effects that the incorporation might have on sales/use and self-employment tax obligations. Ignore any exposure to the corporate or individual alternative minimum tax, though.
The “elephant in the room” will be the issue of the business owner's continued involvement in the business. You should be prepared with some initial suggestions regarding business succession planning and the later transferability of Mimi’s Cupcakes Inc shares.
[caption id="attachment_1276" align="alignnone" width="828"]Most companies dominating the various industries around the world started as mere business ideas, which were implemented through the formation of sole proprietorship startups. Their flourishing led to their incorporation into limited companies; today, they are cherished businesses. That is the same trend and future that Mimi’s Cupcakes Business is aspiring for; hence, the progress towards incorporating the industry is long overdue. Although Mimi fears the outcome of the incorporation, especially concerning assets and taxation, there is less to worry about.
Mimi’s worries revolve around two key aspects. Firstly, Mimi is already of advanced age, and her life expectancy is approximately two years from the scheduled date of starting the business. She has been serving as the owner and the CEO of the startup. Her frequent visits to her cardiologist suggest she has a few years to live. The critical problem is the succession now that her health is deteriorating; at some point, she will be unable to manage the business as usual. She is yet to come to terms with the idea that she will pass her position over to another person. Secondly, it is apparent that tax obligations tied to the businesses that are formally incorporated pose another challenge that her industry is facing. In one of her visits to the cardiologist, she learns that the clinic has been incorporated into a limited company. However, the cardiologist cites that he just retained the land and the building on which the business is situated. In brief, he did not incorporate the two. He, however, fails to tell the owner the reasons that informed his actions. Before incorporating her cupcake business, she needs thorough information about what she is unsure of.
A limited company and a sole proprietorship have different ownership and management styles defined by the company law. As for Mimi’s Cupcakes Business, Mimi is both the owner and the manager. It is legally acceptable now that it is yet to be made a company. Once incorporated, business owners become the shareholders. They automatically lose their stature as managers. Companies law requires newly founded shareholders to elect representatives/ directors to manage the company’s affairs. For small enterprises, the owners might become the directors. If many shareholders come on board, a few directors are elected. The principle of permanent existence or perpetual succession stipulates that the death or insolvency of a shareholder cannot stop the business’s operations (Agrawal, 2016). This is unlike in sole proprietorship, where the death or incapacitation of the owner could lead to the collapse of the business. For example, if Mimi became unable to move or the unfortunate event of her death occurred, Mimi’s Cupcakes Business could collapse and cease in the long term.
As for Mimi’s Cupcakes Business, she is incorporating the enterprise means that its ownership will be distributed among a few shareholders. Mimi’s health is deteriorating. Once included, she will no longer need to retain her business owner and manager position. The enterprise must have a few directors with three shareholders who have already been identified. The directors, through a majority, can vote on who to become the manager/CEO. This way, Mimi will be relieved of managing the enterprise now that her health has worsened.
Incorporating certain assets is a critical dilemma in many businesses, often due to tax obligations. In the USA, IRS classifies assets concerning depreciation. Land and buildings are not subject to depreciation (Murray, 2018). Hence, no depreciation amounts are set aside for them in any accounting period. The company’s law in the USA holds that the two assets appreciate. When owned by individuals, the value added is not subject to taxation. If they are properties of a company, appreciation is interpreted as capital gain, and it is subject to taxation on an annual basis (Youngman, 1996). If a company decides to sell its land or building, it incurs another capital transfer tax. These taxes are often absent in case individuals own the land and buildings. This is explained by the clinic’s owner’s decision not to incorporate the land and the buildings on which his clinic was situated—as for Mimi’s Cupcakes Business, which is still trying to penetrate the market, failing to incorporate buildings and land is a crucial cost-saving strategy.
From the previously mentioned case study analysis, it is manifest that what Mimi is facing is troubling, especially now that there is little information about what happens when an enterprise is incorporated. She plans to incorporate the business and sell shares to three people while she retains the majority shareholding. Now that her health is failing, it is in her best interest to surrender her management position to another person. It is very unwise to have the business’ building and land incorporated. The two assets will start incurring tax immediately. That will be an added cost that can be easily avoided now that the business is attempting to minimize costs and maximize returns to stay afloat.
Agrawal, M. (2016). 10 principal features of an incorporated company. Your Article Library. Retrieved from http://www.yourarticlelibrary.com/company/features-company/10-principal-features-of-an-incorporated-company/75890
Murray, J. (2011). 10 facts you should know about business assets. The Balance. Retrieved from https://www.thebalancesmb.com/business-assets-facts-397849
Youngman, J. M. (1996). Tax on land and buildings. Tax Law Design and Drafting, 1, 1-27. Retrieved from https://www.imf.org/external/pubs/nft/1998/tlaw/eng/ch9.pdf
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Published On: 14-12-2018
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