Hawaiian Memories Inc Tax Research Memo Due Date Wednesday

Hawaiian Memories Inc Tax Research Memorandumdue Date Wednesday N

Prepare a memorandum to the tax manager outlining the tax issues involved in the conversion of Hawaiian Memories, Inc. to S corporation status, including a restatement of facts, identification of at least three main issues, conclusions for each issue, and detailed analysis citing primary authority such as the Internal Revenue Code, Regulations, and Court Cases. The memo should refer to all relevant facts about the corporation's formation, ownership structure, financials, and the recent election to be an S corporation, with emphasis on potential tax implications, loss utilization, and E&P considerations. Use proper memo formatting and include comprehensive analysis to support your conclusions.

Paper For Above instruction

Hawaiian Memories, Inc. (HMI) is a Maui-based corporation established in 2007, primarily engaged in marketing specialty tourism products of Hawaii. The company, originally formed by Angie Lee and Bob Lin, is structured as a C corporation, with several classes of stock held by founders, employees, and a partnership. Recently, the company elected to become an S corporation effective October 1, 2022, intending to capitalize on pass-through losses to offset other income. This decision raises multiple tax issues that need to be thoroughly analyzed to determine the implications of such a conversion.

The fundamental facts include HMI’s asset base, liabilities, and owner equity as of September 30, 2022. The company experienced its first year of losses and expects future losses that they wish to offset against their other income under the S corporation regime. The shareholders include Angie, Bob, and others, with most being native Hawaiians, except for Inge, a Swedish national planning to return to Sweden in a year, and the Plantation Sugar Partnership (PSP), a key supplier of raw sugar, owned by Bob's sister and Bob himself.

This memorandum will analyze the critical issues surrounding the transition from a C corporation to an S corporation, specifically focusing on loss carryforward implications, eligibility requirements under Subchapter S, and the impact on earnings and profits (E&P), which are crucial for determining the taxability of distributions and the proper reporting of income.

Issue 1: Can Hawaiian Memories, Inc. Effectively Convert from a C Corporation to an S Corporation without Violating Subchapter S Rules?

Conclusion: Yes, Hawaiian Memories, Inc. can convert to an S corporation, provided it meets all statutory eligibility requirements, including shareholder restrictions, valid election procedures, and proper corporate consent as of the effective date.

Analysis: Pursuant to IRC §1361 and §1362, a corporation can elect S corporation status if it meets certain criteria, such as being a domestic corporation, having eligible shareholders, and having only one class of stock. In this case, HMI has made an election effective October 1, 2022, and the shareholders—primarily individual residents—are eligible under IRC §1361(b)(1). Additionally, the company’s shareholders all consented to the election, satisfying procedural requirements. It is crucial that the election was properly filed and timely made according to IRS regulations, which appears to be the case here. The corporation's assets, liabilities, and ownership structures align with the eligibility criteria, confirming that the transition is permissible under current law.

Issue 2: Can HMI Utilize Its Accumulated Losses and Operating Losses in Future Years as an S Corporation?

Conclusion: No, the accumulated net operating losses (NOLs) from prior years are generally not directly carried over to an S corporation, but they can influence the basis and loss deductibility in shareholder returns, subject to basis and at-risk rules.

Analysis: Under IRC §1374, NOLs accumulated during C corporation years are not directly transferred to S corporation status; instead, they exist as available E&P. Since HMI elected S corporation status effective October 1, 2022, existing NOLs and E&P become relevant for the corporation's future income and distributions. The corporation's E&P as of September 30, 2022, was $300,000, with zero current E&P for the year. The prior losses, while not directly deductible under the S election, can pass through to shareholders as items of income or loss if the corporation has sufficient basis and E&P funds. The loss carryforward rules under IRC §172 and the basis rules in IRC §1367 determine shareholders' ability to deduct losses reflected from the corporation, especially considering the shareholders' stock basis and loan basis, and the fact that the corporation's total assets and liabilities influence these limitations.

Issue 3: How Does the Change in Earnings and Profits Affect Distributions and Taxability in the Context of S Election?

Conclusion: Since HMI's current E&P for 2022 is zero, distributions to shareholders following the conversion will generally be tax-free to the extent of basis but may be taxable if E&P exists or the distributions surpass basis.

Analysis: Under IRC §1371 and related regulations, distributions from an S corporation are not taxable to shareholders to the extent of their stock basis. The corporation's E&P of $300,000 as of prior to conversion suggests accumulated E&P that could influence the treatment of distributions if the E&P is preserved or revived. Since the current year's E&P is zero, distributions will primarily be considered a return of basis, not income. However, if the corporation later generates positive E&P, distributions could be taxable as dividend income under IRC §1368. Careful tracking of basis, E&P, and the timing of distributions is essential for accurate tax reporting and avoiding unintended tax consequences.

Issue 4: Are There Specific Tax Implications for Non-eligible Shareholders and Foreign Nationals Under S Election?

Conclusion: Generally, non-resident aliens and ineligible shareholders cannot hold S corporation stock; thus, Inge’s participation may disqualify HMI’s S election unless she disposes of her interest or meets specific exceptions.

Analysis: IRC §1361(b) disqualifies non-resident aliens from being shareholders of an S corporation. While Inge, a Swedish national, can be a shareholder under IRC §1361(c)(2), her intent to return to Sweden and potential non-resident status could jeopardize the S election or lead to complex tax issues for her. If Inge maintains her shareholder interest, she may be subject to withholding taxes under IRC §1441, and her presence might cause disqualification if the IRS deems her a non-resident alien. Moreover, non-resident aliens are generally not eligible shareholders, and such holdings could retroactively invalidate the S election, requiring correction or re-election as a C corporation.

Issue 5: What Are the Potential State and Local Tax Implications of the S Election for Hawaiian Memories, Inc.?

Conclusion: State tax treatment varies; Hawaii generally recognizes S corporation status, but specific filing requirements and franchise taxes may apply, requiring careful compliance to avoid penalties.

Analysis: While federal law clearly recognizes S corporation status, state treatment can differ. Hawaii generally conforms to federal S corporation rules but imposes a corporate income tax on S corporations’ income and may require separate filings. Also, Hawaii imposes a franchise tax that might apply to corporate income or gross receipts, depending on their type. Therefore, even after electing S status federally, the company must review Hawaii’s specific rules to ensure compliance and optimize tax outcomes. These considerations include filing deadlines, tax basis adjustments, and potential franchise taxes, which could impact future profitability and cash flow.

Conclusion

The conversion of Hawaiian Memories, Inc. to an S corporation is permissible given all statutory requirements are met, including shareholder eligibility and proper election procedures. However, careful planning and detailed tracking of earnings and basis are crucial for correct tax reporting, especially considering the existing losses and zero current E&P. Additionally, considerations regarding foreign shareholder participation and state tax issues must be addressed to ensure compliance and optimize tax benefits.

References

• Internal Revenue Code §1361 - S Corporation Requirements
• Internal Revenue Code §1374 - Corporate Net Operating Losses and Built-In Gains
• Internal Revenue Code §1362 - Election of S Corporations
• IRC §1368 - Taxable Distributions of S Corporation Earnings
• IRS Publication 542 - Corporations
• Tax Court Case: Musil v. Commissioner, 102 T.C. 147 (1994)
• IRS Revenue Ruling 99-5
• Hawaii Department of Taxation, Corporate S Election Guidelines
• Black's Law Dictionary, 11th Edition, "Earnings & Profits"
• AICPA Accounting & Auditing Guide for Small Business