Six years ago, Leticia, Monica, and Nathaniel organized Lemona Corporation to develop and sell computer software. Each individual contributed $10,000 to Lemona in exchange for 1,000 shares of Lemona stock (for a total of 3,000 shares issued and outstanding). The corporation also borrowed $250,000 from Venture Capital Associates to finance operating costs and capital expenditures.
Because of intense competition, Lemona struggled in its early years of operation and sustained chronic losses. This year, Leticia, who serves as Lemona’s president, decided to seek additional funds to finance Lemona’s working capital.
Venture Capital Associates declined Leticia’s request for additional capital because of the firm’s already high credit exposure to the software corporation. Hi-Tech Bank proposed to lend Lemona $100,000, but at a 10% premium over the prime rate. (Other software manufacturers in the same market can borrow at a 3% premium.) Investment Managers LLC proposed to inject $50,000 of equity capital into Lemona, but on the condition that the investment firm be granted the right to elect five members to Lemona’s board of directors. Discouraged by the “high cost” of external borrowing, Leticia turned to Monica and Nathaniel.
She proposed to Monica and Nathaniel that each of the three original investors contribute an additional $25,000 to Lemona, each in exchange for five 20-year debentures. The debentures would be unsecured and subordinated to Venture Capital Associates debt. Annual interest on the debentures would accrue at a floating 5% premium over the prime rate. The right to receive interest payments would be cumulative; that is, each debenture holder would be entitled to past and current interest payents before Lemona’s board could declare a common stock dividend. The debentures would be both nontransferable and noncallable.
Leticia, Monica, and Nathaniel have asked you, their tax accountant, to advise them on the tax implications of the proposed financing arrangement. After researching the issue, set forth your advice in a client letter. At a minimum, you should consult the following authorities:
• IRC Sec. 385
• Rudolph A. Hardman, 60 AFTR 2d 87-5651, 87-2 USTC ¶9523 (9th Cir., 1987)
• Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ¶9438 (5th Cir., 1967)