Reference no: EM131983359

Problem

Start-up Expenditures. George is successful engineer with an idea to start his own business. He wants to build cogeneration plants that produce both steam and electricity. The engineering is relatively simple. Coal or natural gas is burned to fire a large boiler. Steam from the burner turns a turbine connected to a 50 mega-watt generator that produces electricity sold directly to the local public utility. Excess steam is piped to a host manufacturing plant that uses the steam in some manufacturing process (e.g., textiles). Each cogeneration plant will cost about $50 million to build, but once the plant running it is virtually guaranteed to make a profit if George can ensure that his coal/gas costs are low enough. Each plant's revenue stream is assured by the Public Utilities Regulatory Policy Act of 1978, which requires the local public utility to the purchase the plant's electricity at the utility's own "avoided cost" of production.

George is convinced that his idea will work. He only needs to pull together a few essential items:

1. A suitable host manufacturer that needs steam.

2. Vacant land located near the host manufacturer.

3. A coal/gas supplier who will enter into a long-term supply contract at guaranteed prices.

4. $50 million of financing for each plant.

George forms George, Inc. (GI) and begins to implement his plan through this corporation. It takes 18 months and $500,000 in travel costs and professional fees to nail-down the above items for his first cogeneration plant. And, along the way, he found five additional host manufactures ideally suited for future plants.

GI signs a $50 million financing agreement with the lender on June 1, Y2. The next day GI received its first loan distribution and pays an engineering firm $1 million to prepared construction drawings. GI hired a manager to oversee construction at the first plant while he continues to structure deals for additional plants. GI paid the manager $100,000 during Y2 and another $200,000 in Y3. Over the course of the next 18 months, GI spends another $45 million to actually build the plan. By December 29, Y3, the first plant is fully operational and producing electricity.

Required.

a) Which of the cost described above, if any, are "start-up expenditures"?

b) When can GI begin to amortize its start-up expenditures? [Hint: Base your answer on I.R.S. Letter Ruling 9027002 (May 16, 1990)].

c) Now assume that sometime prior to June 1, Y2, GI formed a wholly-owned subsidiary named Plant #1 Corporation (P1C). GI and P1C enter into a management agreement whereby GI will transfer all the contracts necessary to begin the first to P1C in exchange for a $2 million management fee paid upon closing of the initial financing. Rather than GI signing the financing agreement, etc., everything described in the last paragraph is done by P1C. On June 2, Y2, P1C pays the $2 million management fee to GI. Under the alternative structure, GI's trade or business is limited to negotiating contracts and providing certain management services to operating companies like P1C. In turn, P1C's trade or business is the actual operation of Plant #1. Would these new facts change your answer to part (b)? If so, how and why?