Five years ago, Lacey, Kaylee, and Doug organized a software corporation, DLK, which prepares and sells Online Meetings software for businesses. DLK is a C corporation. Every individual contributed $10,000 to the company in exchange for 1,000 shares of DLK stock (for a total of 3,000 shares). The corporation also borrowed $250,000 from ACME Venture Capital to finance operating costs and capital expenditures.
Because of intense competition, DLK struggled for first few years of operation and corporation sustained chronic losses. This year, Lacey, DLK's president, decided to seek additional funds to finance DLK's working capital.
CME declined to extend additional funds because of money already invested in DLK. High Tech Venture Capital Inc. proposed to lend DLK $100,000, but at a 10 percent premium over the prime rate. First Round Capital proposed to invest $50,000 of equity capital into DLK, but on condition that the investment firm be granted the right to elect 5 members to DLK's board of directors. Discouraged by the "high cost" of external borrowing, Lacey decides to approach Doug and Kaylee.
Lacey suggests to Doug and Kaylee that each of the 3 original investors contribute an additional $25,000 to DLK in exchange for five year debentures. The debentures can be unsecured and subordinate to ACME's debt. Annual interest on the debentures can accrue at a floating 5 percent premium over the prime rate. The right to receive interest payments will be cumulative; that is each debenture holder is entitled to past and current interest payments before DLK's board will declare a common stock dividend. The debentures would be both nontransferable and non-callable. Lacey, Kaylee and Doug have asked you, their tax accountant, to advise them on the tax implications of the proposed financing agreement. After researching the matter, issue your advice in a tax research memo. At a minimum, you should consult the subsequent authorities:
• IRC. Sec 385
• Rudolph A. Hardman, 60 AFTR 2d 87-5651, 82-7 USTC
• Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ||9438 (5th Cir., 1967)