Conversion of Smithon Corporation from a C Corporation to an S Corporation - Case Study Example

Mr. Jones, Prospective buyer for Smithon Manufacturing February 8, Smithon Widgets (a C corporation) A review of Smithon Widgets (a C corporation) addressing the purchase of Smithon stock, as well as the potential for conversion of Smithon Corporation from a C Corporation to an S corporation. Also addressed will be the potential income tax ramifications personally to Mr. Jones, and the potential merger or acquisition of Smithon by Johnson Services. Other interests being addressed are, the potential use of Johnson stock to fund the purchase and the effect a merger would have on the ability of Mr. Jones to change Smithon from a fiscal year end to calendar year end and convert it to an S corporation. You asked that I give you definitive answers regarding the outright purchase of Smithon stock, as well as the potential merger or acquisition of Smithon by Johnson Services. Of these two main issues there are several minor points that need addressed? I will break each section down and answer those questions specifically, definitively responding for each. To be addressed first is, 1. the outright purchase of Smithon stock a. Should you purchase the stock of Smith outright, leaving Smithon intact? What about issuing debt in your Johnson Services company to pay for the Smith Company-would that raise debt to equity issues? It is sometimes better to purchase the stock of Smithon outright, however, in looking at the potential benefit of using the credit power of Johnson Services and issuing corporate bonds you would free up the cash necessary to make changes if they become a need. There is also the added benefit of the debt tax shield. IRC 514 expands on debt-finance income when one uses income gained by borrowing against investment property. (IRC 514) Obviously, an issue is the potential problem with debt to equity, however, given the losses posted by Johnson Services recently it seems expedient to explore corporate bonds or additional share opportunities and use the cash available to re-tool Smithon. By using the available debt tax shield, you stand to benefit in numerous ways from using Johnson Services as a backer for purchasing Smithon. One potential disadvantage is that issuing debt can increase the risk of bankruptcy. (Damodaran 9) b. Should I convert Smithon to an S corporation and change the fiscal year end to a calendar year end? c. What potential income tax ramifications exist for me if I purchase the stock of Smithon and convert it to an S corporation? If you use the credit available from Johnson to purchase Smithon it would be beneficial to retain the C status of that corporation and take full advantage of the corporate tax benefits resulting. However, if you decide to use cash to purchase Smithon and end up with a large personal liability then converting it to S status would become more beneficial. Due to increased taxes on a personal level with the utilization of “mean testing” it would seem more personally beneficial to retain the C status of the corporation and keep the potential income from that business out of the data included in the “mean testing.” The income of an S corporation is generally taxed to the shareholders of that corporation rather than the corporation itself. (IRS form 2553 1) As for changing from a fiscal to calendar year end, this would result in filing a short tax year, and additional expenses administratively with no real net benefit. d. Should I merge Johnson Services and Smithon? What type of merger or acquisition would be best (i.e., A type, etc.)? Because there are no available data sets as to the similarities between Smithon Widgets manufacturing and Johnson Services it would be necessary to further explore the ability for both companies to function together. If a merger becomes an option and is pursued successfully the most effective merger type given the information currently available would be the conglomeration merger. This type of merger is between two businesses that are involved in totally unrelated activities. There is the possibility for a mixed conglomeration merger as well, if the businesses end up having some practices in common, however, as it stands the conglomeration merger would be the best approach. (Conglomerate Merger 1) Delaware corporation law states, “Any 2 or more corporations existing under the laws of this State may merge into a single corporation, which may be any 1 of the constituent corporations or may consolidate into a new corporation formed by the consolidation, pursuant to an agreement of merger or consolidation, as the case may be, complying and approved in accordance with this section.” (Title 8, sec 251) This means that under Delaware corporate ruling as long as there is an agreement of merger it is a legal approach to undertake. However, this does not mean it is the most fiscally prudent approach. To be addressed secondly is, 2. Merger or acquisition of Smithon by Johnson Services a. If the two companies are merged, could Smithon use Johnson Service’s net operating loss carry forwards and are there any limitations on their use? As a net operating loss carry forward is the application of the current year’s operating losses against the next year’s profits, and is done to reduce tax liability we need to ensure that if we merged these two companies early in the year we would be able to apply that legally. Looking at the IRC Sec. 172 we see that the surviving corporation of a statutory merger or consolidation may carry forward the net operating losses of the absorbed company. However, we see in IRC Sec. 269 that there are limits applied to corporations merging specifically to take advantage of tax benefits. (Tax Law 2) b. Should I use Johnson’s Services’ stock to acquire Smithon? Why or why not? c. Would a merger or acquisition affect my ability to change Smithon’s fiscal year end to a calendar year end? Could Smithon be converted to an S corporation? d. Does the potential of significant capital investment in Smithon affect any of the answers for 2 a-c above? It is my opinion based in the above mentioned reasons and substantiating evidence that using Johnson Services’ stock to acquire Smithon would stand to benefit the mutual corporate and individual interests involved. The reason why is based solely in the available tax benefits and the additional fiscal burden of retooling the Smithon plant. Additionally, a merger or acquisition at this time based solely in the available information would more than likely cause additional prohibitive expenses in administration. The IRS has ruled according to publication 544 that, “ In some instances, a company will give you common stock for preferred stock, preferred stock for common stock, or stock in one corporation for stock in another corporation. If this is a result of a merger, recapitalization, transfer to a controlled corporation, bankruptcy, corporate division, corporate acquisition, or other corporate reorganization, you do not recognize gain or loss.” (IRS publication 544) Due to the tax differences between an S corporation and a C corporation it stands to reason that the most overall beneficial approach would be to leave Smithon as a C corporation currently, and approach conversion in the future after the debt load from the retooling and purchase has been partially or fully alleviated. This argument can also be used regarding the desire to convert from a fiscal year end to a calendar year end, prohibitive initial administrative costs would cause the initial purchase to be more expensive than it is potentially worth. Overall, the potential for significant capital investment does weigh heavily on the decision being made. In conclusion the following plan should be followed for maximum benefit for all involved parties. The purchase of Smithon should be undertaken using Johnson Services’ stock or corporate bond offerings. This realizes the need to offset the losses currently being felt with Johnson Services’. No change should be made to the corporate type or year-end approach. Lastly, no merger should be attempted at this date due to the inherent potential tax implications and prohibitive cost of additional administrative staff. Cited references: Conglomerate Merger,. "What Does Conglomerate Merger Mean?" Investopedia 2010: 1. Web. 8 Feb 2011. http://www.investopedia.com/terms/c/conlgomeratemerger.asp Damodaran, A. "The debt equity trade off: the capital structure decision." Stern School of Business ND: 9. Web. 8 Feb 2011. http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch7.pdf IRC 514,. "Internal Revenue Manual, unrelated debt-financed income." IRS.gov. N.p., 2011. Web. 08 Feb 2011. http://www.irs.gov/irm/part7/irm_07-027-008.html IRS form 2553,. "Instructions for form 2553 (rev. December 2007)." Department of Treasury, Internal Revenue Service 2007: 1. Web. 8 Feb 2011. http://www.irs.gov/pub/irs-pdf/i2553.pdf IRS publication 544,. "Sales and Trades of Investment Property, nontaxable trades, corporate stocks ." IRS.gov. N.p., 2011. Web. 08 Feb 2011. http://www.irs.gov/publications/p550/ch04.html#en_US_2010_publink100010443 Tax Law,. "Excerpt of IBFD's online publication Mergers& Acquisitions." IBFD.Org ND: 2. Web. 8 Feb 2011. http://www.ibfd.org/portal/pdf/Excerpt_MergersandAcquisitions.pdf Title 8, sec 251,. "TITLE 8 Corporations CHAPTER 1. GENERAL CORPORATION LAW Subchapter IX. Merger, Consolidation or Conversion." Delaware.gov. N.p., 2011. Web. 08 Feb 2011. http://delcode.delaware.gov/title8/c001/sc09/index.shtml Read More