Q
Below you will find hypothetical business transactions that your “clients” will be entering into. Help your clients structure the business transaction they desire in the most tax efficient manner possible. Describe the most likely tax treatment of the proposed transaction and support with substantive law. Make suggestions about how the transaction may be restructured to get better tax results without deviating too much from the proposed business structure. You are expected to take an aggressive pro-taxpayer position. Justify your position. Major points will be given for making creative arguments; major points will be taken away for missing important tax issues.
Relevant facts follow. When necessary make reasonable assumptions about facts you don’t know, or describe how unknown facts may alter the tax treatment.
Case
Grant and Sherman are partners in Chattahoochee, LLC, taxed as a partnership. The LLC manufactures marching boots for the U.S. army. Historically, the business has always done well, but not as well as recently. Due to the newfound popularity of marching and its effectiveness in the fight against terrorists the LLC’s annual sales have jumped from $30 million in 2015 to $120 million (expected) in 2016. The profit margin stayed steady at 10%.
Grant and Sherman are not doing well. Grant has a failing liver and Sherman has been afflicted by a rare decease that attacks red-haired men. In short, they want to get out of the business.
The business was valued last September by Dr. Nick Riviera at $7 million. Dr. Nick obtained his doctorate in finance from the third-largest university in San Juan, Puerto Rico and will perform any appraisal for $999.95. Grant would like to pass his share of the business to his son, Frederick. Sherman has no kids and just wants to get cash to cover an unrelated tax liability discussed below.
Grant’s basis in his LLC interest is $50,000. His LLC interest is encumbered by debt in the amount of $2,000,000. Sherman’s basis in his LLC interest is also $50,000.
Grant and Sherman have had a few discussions with Meade, an old friend, about the possibility of Meade buying them out. These discussions were always very general and theoretical, but in the past few weeks have gotten more serious. Meade had indicated just a few days ago that he would be willing to go as high as 0.8 times expected 2016 sales.
Grant has quickly realized that it may be beneficial to “transfer” his share of the business to his son as of last year, based on Dr. Nick’s appraisal. To that end a few weeks ago he has put together a basic sale agreement and a promissory note in favor of Blue Coat, LLC, and both parties executed the documents effective as of October 1, 2015. (Grant recalls a discussion he had with his son last fall to sell the business to Frederick. They reached a tentative oral agreement but nothing was committed to paper.) He left some blank lines in the promissory note to fill in as needed to achieve good income and estate tax consequences. He will follow your advice but remember that he is very concerned about the taxability of his estate.
Blue Coat, LLC is a two-member limited liability company. Fifty percent is owned by Old Boots Trust, an irrevocable trust that Grant has set up naming Frederick as the beneficiary. Fifty percent is owned by a private foundation set up by Grant and ran by Frederick. Grant is the manager of Blue Coat, LLC.
On a somewhat unrelated topic, three years ago Sherman struck the following deal with McClellan. McClellan had a business transporting travelers downriver from D.C. to Virginia. He needed the use of river boat engines that Sherman produced through a business unrelated to Chattahoochee, LLC. The river boat engine business is called Tank, Inc., in honor of the nickname given to the engines produced by Sherman. Sherman and McClellan agreed that if Sherman supplied the engines to McClellan at discounted pricing and would give the orders placed by McClellan priority, McClellan would issue to Sherman stock in McClellan’s business (organized as a corporation) amounting to 10% of all outstanding stock. Sherman also indicated that he would drop by from time to time to “listen” to the engines. Although the sale of each engine included access to Sherman’s technicians, Sherman was the undisputed master of the river boat engine, and McClellan appreciated the gesture. They shook hands and the deal was done.
Later in the year McClellan realized that he was becoming very dependent on Sherman’s engines and if the trend continued it would make sense to vertically integrate the business by simply buying the patents to the engines from Sherman and producing them in-house. Sherman, already contemplating retirement, thought it was a dandy idea. He sold McClellan an option to buy the patents with a strike price of $1 million. The option was exercisable immediately and for a period of 3 years. McClellan paid $80,000 for the option. The patents were worth about $900,000 to $1 million when the option was issued.
Yesterday, Sherman called you with distressing news. McClellan mailed a letter to Sherman warning that McClellan’s corporation will be issuing to Sherman a 1099 in the amount of $700,000 for 2015. The letter advised Sherman that the stock in McClellan’s corporation was issued in exchange for Sherman’s services. The stock was subject to a substantial risk of forfeiture for a period of 3 years after issue. That period ran out in December 2015, vesting the stock in Sherman. McClellan was therefore taking the position that in 2015 his corporation paid Sherman $700,000 in the form of stock in exchange for services provided by Sherman to McClellan’s corporation.
Sherman does not recall that the stock was subject to a risk of forfeiture, but he is not certain as the agreement was concluded on a handshake.
The option lapsed in December of 2015.
Your senior partner is relying on you to spot all relevant issues, offer an analysis of each issue, suggest likely tax consequences and alternate tax treatment where appropriate and to make arguments that would result in the best possible federal tax consequences for Grant and Sherman. Separately, but in addition to the above, advise Sherman on the most tax-efficient way of converting Tank, Inc. into an entity taxed more favorably than a corporation
