Balancing tax planning with investor attractiveness
Joe Faboozi, an entrepreneur, wants to form a corporation with his partner Paul Prince. They want to develop a new fiber multiplexer.
Joe is rich. He generates over $50MM/year and he can afford to drive a Porsche to work. He is open to contributing a majority of the capital needed to start the company. He wants to contribute $5MM in cash, will provide a favorable rental discount in his office for Paul (at $4K / month, FMV $6K/month), furniture of $30K, computers of $100K, software $5K, and admin staff valued at $8K/month. He will provide the money and only work on the "big stuff" or help close deals.
On the other hand, Paul is the young buck. He just graduated from USC two years ago and many of his classmates went to work for startups. He wanted to work for himself and met Joe at a venture capital event and together they hit it off. Paul has expertise fiber optics and engineering. He realizes that the high tech field is a gold mine. He is willing to put in sweat equity to start the firm. He doesn't have a lot of cash but will be able to put in $10K + take a reduced salary in the first year to get it up and running and have a higher weighted bonus based on certain performance criteria - (development of prototype, secure first OEM sharing agreement. Paul will do most of the legwork to create the business
Joe will own 80% of the business and Paul will own 20%. They have not decided on the entity structure but heard that the C Corporation has advantages and disadvantages. They project that in the first year they will probably the following expenses
$2.0MM to develop the fiber multiplexer prototype - R&D costs
$1.5MM to develop technology team (hire or outsource)
$300K for general and admin, Paul receives salary of $70K + potential bonus of $70K, Joe only receives a salary of $50K
$250K for startup marketing and develop sales force
$25K for legal fees
Joe wants the corporation to pay for his lease on his Porsche - payment of $3K/month. Joe also wants to corporation to be a funnel for various personal expenses - fitness trainer, trips to Vegas etc. Paul needs a loan of $250K to make a down payment on his house,and wants the corporation to lend him the money. Joe is ok with it. Paul wants to be paid 3 times the market rate for a CEO next year because he feels that he deserves it and is much more valuable than Michael Eisner. They will also invest $2MM in IBM and receive dividends of $100K before they use the money for the prototype.
They have some other interested parties that may want to invest the company. JCV, a noted VC firm will lead a first round of financing if the prototype is successful and is willing to lead a round of $20MM for a 35% equity stake.
They are coming to you for your expertise. They want to best entity for tax purposes but that would also attract investors. They also want a detailed projection of how much money they would save in taxes for these losses and how to structure some of their shareholder transactions. Please keep your letter to four pages, double-spaced with adequate margins. Do not use code sections and remember that the audience has very little understanding of taxes. There can be a multiple of answers to this issue, it is a juicy case. I'm looking for well thought responses and identification of issues, as well as your written communication skills. Remember you are the consultant and they are the client.