Question

Mr. Java (“Java”) has operated a chain of coffee houses as a sole proprietorship over the past three years and is now interested in expanding his horizons and limiting his liability. To do so, he wishes to incorporate, raise $150,000 of additional capital and hire an experienced person to manage the business. He has located Venturer, who is willing to invest $150,000 cash and Manager, who has agreed to serve as chief operating officer if the terms are right.

The parties have decided to join forces and form Java Jyve, Inc. (“Jyve”) to expand the coffee house business and offer access to the Internet at every location. Java will transfer assets with an aggregate basis of $50,000 and a FMV of $200,000 (do not be concerned with the character of the individual assets for this problem); Venturer will contribute $150,000 cash; and Manager will enter into a five-year employment contract. Java would like effective control of the business; Venturer is interested in a guaranteed preferred return on his investment but also wants to share in the growth of the company; and Manager wants to be fairly compensated (she believes her services are worth approximately $80,000 per year) and receive stock in the company, but she cannot afford to make a substantial cash investment. All the parties wish to avoid adverse tax consequences.

Consider the following alternative proposals and evaluate whether they meet the tax and non-tax objectives of the parties:

(a) In exchange for their respective contributions, Java will receive 200- shares and Venturer will receive 150 shares of Jyve stock. Manager will agree to a salary of $40,000 per year for five years and will receive 150 shares of Jyve common stock upon the incorporation. (Assume that the value of the stock is $1,000 per share.)

(b) Same as (a), above, except Manager will receive compensation of$80,000 per year and will pay $150,000 for her Jyve stock. Any difference if Manager, unable to raise the cash, gave Jyve the unsecured $150,000 promissory note, at market rate interest, payable in five equal installments, in exchange for her 150 shares?

(c) Same as (a), above, except Manager will pay $1,000 for her 150 shares and the incorporation documents specify that she is receiving those shares in exchange for her cash contribution rather than for future services.

(d) Same as (c), above, except Manager will pay $20,000 cash rather than $1,000.

(e) Same as (d), above, except Manager will receive only 20 shares of stock without restrictions; the other 130 shares may not be sold by Manager for five years and will revert back to the C if Manager should cease to be an employee of the company during the five-year period. See LR.C. §83. Would you advise Manager to make a §83(b) election in this situation? What other information would you need?

(f)In general, is there another approach to structuring the formation of Jyve that would harmonize the goals of the founders?

Answer 1

Part a:

The shares of Jyve Stock will be issued to Java and the venture which will make them the owners of the company. The payment of salary to the manager of $40000 can be deducted from the revenue of the company annually to ascertain the amount of assessable profit of the company on which the tax is to be paid by the company. Since the manager will also receive shares of the company upon its incorporation only the salary which is commensurate with the market rate shall be allowed as deduction in computing the assessable profit of the company.

Part b:

The compensation of $80000 to the manger will not be allowed as deduction in computing the taxable profit of the company as it is in all probability far in excess than the commensurate compensation for the manager as the manager in earlier was paid $40000 per year. The issuance of shares will not have any tax benefit from the perspective of the company as this will not be allowed as deduction in computation of assessable income of the company.    

Part c:

Though no additional compensation is being paid to the manager the company will be allowed to deduct any expenditure as manager salary to compete the assessable income of the company. This shall be calculated by taking into consideration the market value of 150 shares reduced by the $1000 paid by the manager.

Part d:

The market value of 150 shares if more than $20000 as on the date of allotment of these shares then the excess amount over and above $20000 shall be considered as the manager salary to compute the assessable income of the company.   

Part e:

Since the right in 130 shares is significantly limited with the restriction of selling for the next five years, the manager should not make election under section 83(b) in that situation. Other information include the information about the beneficial rights in the shares of the company and the right to receive dividend of the manager on all 150 shares of the manager.

Part f:

In order to achieve the tax and non-tax objectives, the company needs to comply with the provisions of the legislations governing the operations of companies and the income tax provisions for companies in the country.