Aristocrat, Baker, and Chef have formed Chez Guevara, Inc. (Chez) as a C corporation to operate a gourmet restaurant and bakery previously operated by Chef as a sole proprietorship. Aristocrat will contribute $80,000 cash, Baker will contribute a building with a fair market value of $80,000 and an adjusted basis of $20,000, and Chef will contribute $40,000 cash and the goodwill from his proprietorship with an agreed value of $40,000 and has a zero basis. In return, each of the parties will receive 100 shares of Chez common stock, the only class outstanding.

Chez requires at least $1,800,000 of additional capital in order to renovate the building, acquire new equipment, and provide working capital. It has negotiated a $900,000 loan from Friendly National Bank on the following terms: interest will be payable at two points above the prime rate, determined semi-annually, with principal due in ten years and the loan will be secured by a mortgage on the renovated restaurant building.

Instructions:

Evaluate the following alternative proposals for raising the additional $900,000 needed to commence business, focusing on the possibility that the Service will reclassify corporate debt instruments as equity.

1. Aristocrat, Baker, and Chef each will loan Chez $300,000, and each will take back a $300,000 five-year corporate note with variable interest payable at one point below the prime rate, determined annually.

2. Same as (a) above, except that each of the parties will take back $300,000 of 10% 20-year subordinated income debentures; interest will be payable only out of the net profits of the business.

3. Same as (a) above, except that the $900,000 loan from Friendly National Bank will be unsecured but personally guaranteed by Aristocrat, Baker, and Chef, who will be jointly and severally liable.

4. Aristocrat will loan the entire $900,000, taking back a $900,000 corporate note with terms identical to those described in (a) above.

5. Same as (d) above, except that commencing two years after the incorporation, Chez ceases to pay interest on the notes because of severe cash flow problems.