Facts: Elon Musk and Shelon Musk (not related, just a weird coincidence) are the two individual shareholders of Talker, Inc. ("TALKER"), a Delaware corporation that operates a social media platform solely dedicated to discussing electric vehicles (discussion of any other topic is immediately deleted and the user permanently banned). Elon and Shelon each own 500 voting common shares of TALKER stock, which constitutes all of the TALKER stock outstanding. TALKER is not doing well financially and has taken on a large amount of debt to stay afloat. TALKER needs to radically change its business in order to continue operating, so Elon and Shelon would each like to advance additional funds to TALKER so that it can rebrand itself and relaunch its platform. Elon would like to advance $50,000 to TALKER and Shelon would like to advance $60,000 to TALKER, and both would like to do so on nearly identical terms. However, Elon would like his funds to be advanced in exchange for a TALKER note (the "NOTE"), while Shelon would like to advance her funds in exchange for newly-issued shares of TALKER preferred stock (the "PREFERRED STOCK"). The NOTE would bear interest at a rate of 7%, which is roughly equal to the average rate of interest borne by TALKER's third-party debt today, and it would have a term of 20 years. Very similarly, the PREFERRED STOCK would provide a fixed return of 7% of issue price every year, and it would be mandatorily redeemed by TALKER for the issue price on the date that is 20 years from issuance. In both cases, the annual 7% return must be paid in cash on an annual basis as either an interest payment (in the case of the NOTE) or a distribution on preferred stock (in the case of the PREFERRED STOCK), with no deferral permitted. Both the NOTE and the PREFERRED STOCK would give the holder the right to appoint one member of the TALKER board of directors, which currently has three members but would be expanded to five members. Elon and Shelon admit that given TALKER's current financial situation, it would not be able to borrow as much as $50,000 from a third-party bank at a 7% interest rate with a 20-year term. Before Elon and Shelon's additional advances, TALKER has an internal and external debt-equity ratio of 5:1. These ratios are in excess of industry norms for a mature business in TALKER's industry, but Elon and Shelon point out that they are roughly standard for the debt-equity ratios of a start-up tech company, and they argue that TALKER should be viewed as a start-up because it is attempting to rebrand and relaunch. 

 

Questions: 

(a) What would you advise Elon about whether the NOTE will be respected as debt for U.S. federal income tax purposes? 

 

(b) Would the NOTE be more or less likely to be respected as debt if Shelon also decided to provide her advance in exchange for a note bearing identical terms to the PREFERRED STOCK? 

 

(c) How would you attempt to convince Shelon that it is more advantageous for her to advance cash to TALKER as debt rather than equity from a U.S. federal income tax perspective?