Jerry purchased PODS that he leases to customer to store household goods. He invested $250,000 and borrowed $1,000,000 to purchase the PODS. Presently $300,000 is due on the note and the balance is payable over the next five years. Jerry does not have the cash to make the $300,000 (plus 7% interest) due this year, so he went to see the Pirates about a loan. Jerry has prepared the taxable income and cash flow projection presented below. Jerry has depreciated for two years the seven year assets. The book value of the PODS is $765,000 and their market value is $1,020,000.
Pirate #1: If these numbers are right, this looks like a pretty sweet deal.
Jerry: Oh, those numbers are right!
Pirate #2: We're ready to load-up. The only thing we don't know is your fee.
Jerry: My fee. What the heck are you talking about! I want you to loan me the money. Its my deal.
Pirate #2: Jerry, we're not a bank!
Pirate #1. We know you can't make the $300,000 payment and as a result we can probably by the PODS cheap at a foreclosure sale, but we don't want to leave you out so here's what we can do. We will create an LLC, Pirate #1 and I will each contribute $150,000 cash to make the $300,000 payment on the note (cash flow should be sufficient for the interest). You contribute the PODS and the LLC will take on the bank note. I know that you have personal liability on the note, but we don't want the bank to get involved in our transactions and cause us to spend money and time to get a new note, so if you have to pay the bank, we will reimburse you for our share. Pirate #2 and I will be allocated all of the losses and then the profits until we recover the losses and then you will get 25% of the profits, and we will get 75%. You can't use the losses nearly as well as we can, since you are only in the 20% tax bracket. As you know we (Pirate #2 and I) are in the 45% bracket.
a. Compute the partners' bases in the LLC immediately after the formation of the venture.
b. Does the plan of allocations satisfy the substantial economic effect requirements?