Lucy has operated a successful Italian import supply business as a sole proprietor for five years. She now plans to dramatically expand her business. To this end, she has lined up some new capital and developed the following plan:
1. She will form a C Corporation that will have four shareholders: Lucy, Jim, Sue and Dave.
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2. Lucy will contribute to the corporation accounts receivable that have a value of $100,000 and a basis of zero. She will be issued 100 shares of common stock in return.
3. Jim will contribute $100,000 cash in return for 100 shares.
4. Sue, a recognized expert in Italian goods, will sign a five-year agreement to manage the business. As a signing bonus, she will be issued 100 shares of stock.
5. Dave will contribute a warehouse to corporation I return for 100 shares of stock. The warehouse has a value of $500000 a mortgage balance of $ 400000 and a tax basis of $ 250000. The company will assume the mortgage.
6. Each of the four shareholders also will loan the company $ 450000. The loan, plus the interest at prime, will be paid off in monthly installments over a ten-year period. No payments will be due the first twelve months, then interest-only payments will be due for three years, and then the principal plus interest will be amortized over a six-year period. The projection shows that the company should have no problem with this payment schedule if things go as planned.
Advise Lucy on the tax impacts of her plan. What changes would you suggest? Why? How would you advice change if Lucy plans to use an S corporation, not a C corporation?