Six years ago, Leticia, Monica, and Nathaniel organized Lemona Corporation to develop

and sell computer software. Each individual contributed $10,000 to Lemona in exchange

for 1,000 shares of Lemona stock (for a total of 3,000 shares issued and outstanding).

The corporation also borrowed $250,000 from Venture Capital Associates to finance

operating costs and capital expenditures.

Because of intense competition, Lemona struggled in its early years of operation and

sustained chronic losses. This year, Leticia, who serves as Lemona’s president, decided to

seek additional funds to finance Lemona’s working capital.

Venture Capital Associates declined Leticia’s request for additional capital because of

the firm’s already high credit exposure to the software corporation. Hi-Tech Bank proposed

to lend Limona $100,000, but at a 10% premium over the prime rate. (Other software

manufacturers in the same market can borrow at a 3% premium.) Investment

Managers LLC proposed to inject $50,000 of equity capital into Lemona, but on condition

that the investment firm be granted the right to elect five members to Lemona’s board

of directors. Discouraged by the “high cost” of external borrowing, Leticia turned to

Monica and Nathaniel.

She proposed to Monica and Nathaniel that each of the three original investors contribute

an additional $25,000 to Lemona, each in exchange for five 20-year debentures.

The debentures would be unsecured and subordinated to Venture Capital Associates debt.

Annual interest on the debentures would accrue at a floating 5% premium over the prime

rate. The right to receive interest payments would be cumulative; that is, each debenture

holder would be entitled to past and current interest payents before Lemona’s board could

declare a common stock dividend. The debentures would be both nontransferable and

noncallable.

Leticia, Monica, and Nathaniel have asked you, their tax accountant, to advise them

on the tax implications of the proposed financing arrangement. After researching the

issue, set forth your advice in a client letter. At a minimum, you should consult the following

authorities:

• IRC Sec. 385

• Rudolph A. Hardman, 60 AFTR 2d 87-5651, 82-7 USTC ¶9523 (9th Cir., 1987)

• Tomlinson v. The 1661 Corporation, 19 AFTR 2d 1413, 67-1 USTC ¶9438 (5th Cir.,

1967)