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Adapted from the 2020 Deloitte Tax Competition
Quinn Parker and Taylor Parker are two family members behind a new business venture they
are calling Modems for All. Quinn is also the CEO of Industrial Kitchens, Inc., a long-time
Deloitte client. The new venture that they are starting will manufacture a new high tech
modem that will provide reliable internet access at relatively low cost. They believe this
advance in technology will help address the issue of internet access for school children who
need to learn remotely. They are looking for advice on how they should structure this venture.
Background Information
Later in this file, you’ll find information regarding the projected earnings for Industrial Kitchens
and Modems for All along with some personal tax information about the owners. For now,
here’s an overview.
Quinn Parker and Industrial Kitchens. Quinn Parker is the CEO of Industrial Kitchens, Inc., (IK)
an S Corporation that is known worldwide for their high-quality, cutting edge industrial kitchen
equipment used in restaurants. Industrial Kitchens is located in Smalltown USA. It is a family
usiness that provides work for a substantial number of employees in the local area. Quinn’s
great-grandfather started Industrial Kitchens 50 years ago, and the company has thrived and
grown to $20 million in annual sales with profits typically hovering between $3.0 and $3.5
million.
Taylor Parker. During the 2019 holiday season, Taylor Parker (the child of Quinn’s
other and a
ecent electronic engineering graduate) talked with Quinn about a project that Taylor had spent
a considerable amount of time developing. With some assistance from a group of engineering
friends, Taylor had developed a modern modem that would provide internet access across land
lines or via a mobile phone. The modem would have a power booster that would make the
technology viable in most remote areas. Taylor’s belief was that this modem would be the
answer to providing inexpensive internet access to those who had not previously been able to
afford it. Taylor wanted to meet with Quinn in a few months to talk about how to obtain
financing to start producing the high-tech modem.
By early 2020, Taylor had become even more convinced about the benefits of implementing the
modern modem idea. Taylor felt that they had a distinct advantage in having already
completed much of the development of the idea. As the COVID-19 pandemic emerged, access
to the internet had frequently been in the news, especially with regard to education.
Of special interest to Taylor was the possibility of addressing the critical issue of on-line access
for elementary students. Taylor’s engineering collaborators had moved on to focus on other
endeavors, so while they supported moving ahead with the idea, they were comfortable
negotiating a sale of any rights they held in the technology.
Industrial Kitchens and Modems for All (MFA). In early April 2020, Quinn realized that the social
distancing rules being enacted due to the COVID-19 virus would negatively impact the business
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of Industrial Kitchens. He did not believe that restaurants would be updating their equipment
or opening until the virus was under control. The second quarter of 2020 was shaping up to be
one of the worst in company history and Quinn had no confidence that business would improve
in the short term. Accordingly, revised forecasts for the year showed a significant drop off in
usiness, resulting in a small projected profit for the year. However, Quinn had a strong sense
of responsibility to his employees and wanted to find a way to keep his employees working.
It’s then that Quinn remembered his discussions with Taylor and thought the modem
innovation was something that showed great promise given the essential role it could play with
usiness, education and other activities moving to an online format. After discussions with his
advisors and his sister, Diane Lincoln (another major shareholder in IK), Quinn approached
Taylor about the possibility of financing the new business venture to pursue the manufacturing
of the modems. Quinn was aware that pivoting his business to a new product was not without
isk. He is not familiar with the technology needed to manufacture the modem and would be
elying heavily on Taylor’s expertise. He expected to incur a number of costs associated with
moving in this new direction including retraining, marketing and building a reputation in a new
market. While all indications were that the demand for this type of modem would cause the
usiness to be profitable very quickly, Quinn was concerned about possible disruption in the
supply chain of raw materials especially considering the potential impact of COVID-19 on
worldwide businesses. However, Quinn decided that it was worth the risk as not only would it
solve a short-term problem during the COVID crisis, but it would also provide an opportunity for
expansion that is needed as Industrial Kitchens appeared to have limited growth potential in
the future.
Organization Form Decision: As the service providers to IK, Quinn and Taylor have asked us for
advice as to how to structure the new business venture. They are considering several options.
First, they can have Industrial Kitchens operate or own the entire business of manufacturing
and selling the modems. They would conduct the new business under the trade name of
Modems for All (MFA) or in a separate entity of the same name owned 100% by IK. Industrial
Kitchens has an old warehouse that is in good repair that could be used for the manufacturing.
They estimate they will need $2,500,000 to hire employees, purchase equipment and get the
manufacturing up and running. That money is cu
ently available in Industrial Kitchen so no
loans will be needed. In addition, they determined they will pay $250,000 to purchase the
ights of the modem technology from Taylor’s engineering friends.
The second option would be to create a separate entity for the new modem company that will
e called Modems for All (MFA). The new entity would lease the building space from Industrial
Kitchens. Industrial Kitchens would make a special distribution of $2,500,000 in cash to its
shareholders. Quinn is aware that all shareholders of IK have sufficient stock basis so that this
distribution will be able to be accomplished tax free. As a result, the new company, MFA, would
have the same ownership as IK (after the gift discussed below).
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Each of the shareholders will invest their distribution into the MFA business. Diane Lincoln is
single and believes she has more money than she can spend in her lifetime; accordingly, she has
decided to gift 1/3 of her shares in IK (10% of the Company) to Taylor. Diane believes the
timing is to her advantage, as the first quarter was a poor quarter and the share value is
arguably at its lowest in recent years. Therefore, the gift of the shares will be done in advance
of any distributions being declared. Diane is comfortable that no cu
ent gift tax will result
from this gift.
Quinn expects to be fully involved in both the business of IK and the business of MFA no matter
how structured. Quinn, as well as each of the other shareholders in IK, have consistently had
significant income, such that all are well into the top tax
acket. While both Quinn and Taylor
would be fully involved and active in IK and MFA, the other investors would clearly be
shareholders only.
Quinn has supplied us with projected numbers for the two businesses for 2020. Please see
attached Excel spreadsheet (Sch 3 forecast)
Issues Summary
Quinn and Taylor would like our advice on how to structure MFA. More specifically, they want to know
which option will result in the greatest after-tax income in the cu
ent year. To gain an understanding of
the implications of this decision, we need to compare the after-tax income depending on whether they
decide to operate MFA as part of IK or as a separate C corporation.
Steps to Complete
1. Start by completing the total federal income tax cost if Modems for All operates as part of Industrial
Kitchens. Under this option, the operations will be combined and the organization will continue to
operate as an S corporation. Information about the taxable income and deductions for the
operations is included in the spreadsheet (attached at the end of this file). To complete this
analysis, you will need to determine the income of the S corporation under the following two
options:
– Calculate the ordinary income of the S corporation if the company decides to depreciate the
equipment without using any provisions that will accelerate the cost recovery (for example,
onus depreciation and/or Sec. 179).
– Calculate the ordinary income of the S corporation if the company decides to use Sec. 179 and/or
onus depreciation.
Once you’ve calculated the ordinary income of the S corporation, you will then need to:
– Calculate the impact on the tax liability of the shareholders. This step will include the calculation
of the qualified business income deduction for the shareholders.
2. Next, complete the total federal income tax cost if Modems for All operates as a separate C
corporation. Under this option, IK will continue to operate as an S corporation, while MFA will
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operate as a C corporation. To calculate the after-tax income, you will need to consider the effects
of each. This step will involve the following:
– Calculate the ordinary income of the S corporation and the related tax liability for the
shareholders, including the effect of the qualified business income deduction for the
shareholders.
– Calculate the taxable income and the tax liability for Modems for All as a C corporation. To
complete this analysis, you will need to determine the income of the C corporation under the
following two options:
– Calculate the taxable income of the C corporation if the company decides to depreciate the
equipment without using any provisions that will accelerate the cost recovery (for example,
onus depreciation and/or Sec. 179).
– Calculate the taxable income