We can work on Memorandum - Write My Academic Essay

TO: Rich Brown

FROM:

CC: Rob Brown; Speedy Brown; Dick Brown; Brown Family Trust

DATE: 7 DECEMBER 2019

SUBJECT: IN-DEPTH ANALYSIS OF TAX CONSEQUENCES

This memo serves to address all the concerns raised by the shareholders that will actively remain in Brown Brothers’ Construction Inc (BBC) as well as those raised by Rob Brown, regarding the tax consequences to all aforementioned parties. It will go on to cover the matter of the Retained Earnings Balance post-redemption of shares by Rob and provide alternatives and suggestions that may bring about better tax consequences for all stakeholders. The in-depth analysis will cover both the quantitative and qualitative consequences of the redemption of shares by Rob.

Firstly, for a section 8, 1982 SEC redemption of shares, from a logical standpoint would imply a price to be paid. In this case we have got the information on hand on the payment arrangement that has been proposed. A key factor that will have a role to play is the time value of money of which this has been mentioned as a 15-year installment financing deal with interest. We will return to this at a later stage. Also. to set the tone, IRS Publication 544 speaks on gains and losses from sales of a capital item, so it must be noted that the stocks being redeemed after a long holding period of 15 year are a long-term capital item thus, there is implied long-term capital gains tax.

From a taxation point of view, the redemption of the shares would be treated as a disposal of the shares (Correa, 2003) and with a disposal of shares, we can expect either a capital gain or loss, for which Capital Gains Tax is charged but only in the instance of a gain. The redemption of shares in this case would give rise to Capital Gains Tax. The capital gain will be the difference between the Tax Base amount which is what the shares cost and the amount the shares are being redeemed at. The reason is that there is an assumption that the shares will be sold to again to one of the other shareholders or a few of the shareholders may look to purchase more shares. The subsequent sale of shares is what would trigger this tax. The difference between amount received for shares less costs incurred, and price paid for redemption would then constitute the Capital Gain or Loss which can then be taxed at an effective rate.

For Rob, the sale of his shares back to BBC would constitute a disposal of shares. As a result of the deal he has been offered where payment will happen in the form of installments with interest accruing each year end and being payable, I would suggest that Rob proportionately defer payment of Capital Gains tax, if there is any after we have determined that, and then match this with the time period in which the redemption payments occur or when the redemption obligations have been fully recognized. His Capital Gain would fall under the Long-Term bracket (IRS, 2018), if there is one, as the shares have been held by Rob for more than a year. To gauge the rate at which the Capital Gain would be taxed, we would need to look to see which Income Tax Bracket Rob would fall under. We have been given further information which takes us one step closer to determining whether there is a gain or loss, in the form of the tax base for Rob’s 300 shares, which is 575 000. To calculate his tax bracket, we have to sum up his income for the 2019 taxation year which would be as follows, contingent on whether he agrees to the deal or not:

Initial Redemption Amount                  200 000
Redemption Amount Accrued                  2 400 000       -Earlier of receipt or accrual-
Interest Accrued (Table 1)                        –
Pro-rata shares of Dividends earned 58 500

325/1000 x 180000
Attribution rules applied here

(Cohen, 2017)

Total 2 658 500

Rob is also married so his bracket would be slightly different as a result of this. With the redemption, regardless of marriage in community of property or not, the amount he would have earned would be above the last threshold for long-term gains meaning that a rate of 20% would be used. Also, the attribution rules of section 318 of the Income Tax Regulations apply as Rob has an option to indirectly purchase 5 shares from Rich and also due to the partnership, means Rob has indirect ownership stakes in BBC which would remain post redemption at 2.5%.

The calculation for Capital Gains would be as follows:

Proceeds 2 600 000
Tax Base Cost -575 000
Capital Gain 2 025 000
Capital Gains Tax @ 20%= 506 250
This amount will be the amount taxed on Rob for the disposal of the shares if he accepts the deal.

Where it gets tricky is with regards to the fact that Rob and Rich also have a mutual fund, R & R Investments which has a shareholding of 50 shares in BBC, with an equal shareholding of 25 shares each. If these were to also be disposed by Rob, the method to make use of for the mutual fund would become a factor to consider. I would advise trying out all methods applicable as per IRS regulations and gauging to see which one would reap the most in tax benefits. The four methods available would be Actual Cost using FIFO, Actual Cost using Specific Identification, Average Cost with Singular Category and Average Cost with Double Category. I would also suggest exploring the option as it has been 15 years, and the concerning matter would be of the disinterest in the corporation which could still be felt through R&R Investments’ involvement. A tax base for those shares would then need to be determined as well and a selling price that matches the market. If they were to continue operations as a partnership of equal standing, this would mean that any interest that Rob earns as will be seen in Table 1, per year will be apportioned according to the agreement. If Rob decides to use his option to buy the extra 5 shares in the Investment fund, then that would subsequently change what Rich would get from Rob’s accrued interest. If any disposal were to occur of these shares in the foreseeable future, the interest carried would also be included in the calculation for Capital Gains or losses as deferral is allowable making that fall under the same rules as other usual amounts for Capital Gains Tax purposes.

We must also address the actual receipt of the shares from the redemption. If there is a share split distribution as part of the redemption, then BBC must expect it to be treated as a dividend distribution (Correa, 2003). This would equate to the market value on the date of the redemption of which in this case, would be the earlier of payment of the first installment and accrual of payment of the first installment to Rob, which would be the 31st of December 2019. The 15-year installment plan effectively means that the share redemption can be fully recognized on fulfillment of each obligation. Thus, a payable is created at the beginning of the installment period in 2019 which is equal to the full fair value of the redemption from which we would treat this as a financial instrument and as a result, an amortization table would be drawn up to show how much interest would be allocated along with the coupon payments each year. Since there is a 5% interest charged yearly on the unpaid balance, this will also form part of the amortization table. This is Table 1, shown below:

Year
Opening Balance
Coupon Payment
Interest accrued-5%
Closing Balance

0
2 600 000
(200 000)
–
2 400 000

1
2 400 000
(160 000)
112 000
2 352 000

2
2 352 000
(160 000)
109 600
2 301 600

3
2 301 600
(160 000)
107 080
2 248 680

4
2 248 680
(160 000)
104 434
2 193 114

5
2 193 114
(160 000)
101 656
2 134 770

6
2 134 770
(160 000)
98 739
2 073 509

7
2 073 509
(160 000)
95 675
2 009 184

8
2 009 184
(160 000)
92 459
1 941 643

9
1 941 643
(160 000)
89 082
1 870 725

10
1 870 725
(160 000)
85 536
1796 261

11
1796 261
(160 000)
81 813
1 718 074

12
1 718 074
(160 000)
77 904
1 635 978

13
1 635 978
(160 000)
73 799
1 549 777

14
1 549 777
(160 000)
69 489
1 459 266

15
1 459 266
(160 000)
64 963
1 364 229

An example of the interest accrued calculation would be for year 1, (5% x (2 400 000- 160000)) which would give us an interest of 112 000. This amount of 112 000 constitutes the amount charged on the unpaid balance for year 1 after the yearly payment of 160 000 has been made. The amount for interest unlike the coupon payments, will change for each year but the method in which it is calculated will remain consistent. This accrued amount for interest is then added to the carrying amount after the coupon deduction to then form the closing balance, which is then carried forward to the next year as the opening balance for the next calculation until the 15th installment for which, the redemption then concludes. The amortization table above shows the interest amounts for each year that accrue to what has to be paid to Rob over and above the coupon payments for each year right up until the last year of installments. A payable remains after year 15 of 1 364 229. BBC could opt to factor that into their yearly payments so as to avoid accrual of the mammoth payable at the end of year 15 or they could come up with a new payment plan for that amount which may lead to more interest being accrued in the future. Debt or retained earnings could be used to cover the finance part of the deal. Reserves show that Retained Earnings as of 2018 were at 2 480 000 post dividend distributions. Reserves show that BBC would have the capacity to pay the arrears to Rob. The interest accruals each year would attract tax deductions for BBC on the earlier of payment or accrual.

When it comes to the usual Income Tax for 2019, the calculation that BBC will come up with will highly likely differ to the one the IRS will have meaning that there would be deferred tax which would have to be accounted and provided for. This will most likely be gained due to the fact that BBC is funding a redemption of shares from Rob through it’s reserves. The Income Tax as per the Income Statement for Financial Reporting Purposes would be:

1 211 217 x 21% = $254 356 (Profits after tax)
This will differ from the amount from the IRS in respect to how some items are treated for tax purposes and changes that occur yearly. Post-year adjustments for amounts that will be discovered in 2020 will also have an effect on the amount leading to the amount differences that will lead to deferred tax adjustments having to be done.
There are amounts which will be subject to deductions on the Income Tax Statement for Tax purposes, like Charitable Donations, Dividends which are exempted after inclusion as Income for shareholders and for Rob, interest earned, which is also exempt. Some expenses incurred will also be subject to deductions.

For BBC, there is no taxable effect of the redemption being done by Rob up until the point whereby his shares have been issued once again at which now potentially a gain or loss can arise from this point. The Base Cost would be appended to what was paid to Rob and the Proceeds would equal the Open Market Value.

Lastly, I will calculate what will remain in the reserves of BBC regarding Retained Earnings or Accumulated Earnings and Profits immediately after the redemption has occurred. The calculations are as follows:

Opening Balance- Retained Earnings 2 480 000

As of 01/01/19

Profits earned in 2019 after tax 254 356
Dividend Distributions -180 000
Redemption of shares – W1 –2 289 288
Closing Balance- Retained Earnings 265 068
W1-The amount that will affect the Retained Earnings is dependent on how much has been redeemed from Rob by BBC. In this case, BBC has only redeemed the 300 shares which are separate from the partnership. This means that the 25 shares from the partnership remain signifying a 92.31% redemption of shares. This portion is the same one that will be financed through Retained Earnings instead of the full amount as this is capital in nature. Hence, 92.31% x 2 480 000 = 2 289 288.
Therefore, what would remain in Retained Earnings would be $265 068. This complies with the requirement of having adequate retained earnings to finance a redemption under section 3 (1) of the SEC Rules Governing Redeemable and Treasury Shares of 1982.

I hope that this clarifies and demystifies all parties with regards to the redemption and all the consequences thereafter. My suggestion would be to try and restructure the redemption to just over a significant level (over 50%) like 51% redemption or to a point where Rob has minimal but significant interest in the company so that the Retained Earnings reserves are kept sufficient enough so as to keep the company operating as a going concern in the foreseeable future and still be able to transition management to keep the company’s best interests at heart.

Yours Sincerely