#11705 - Capital Structure - Corporate Tax (Duke Zelenak)

1. Equity: issuing stock in exchange for contributions of money

   1. Double tax: dividends includible in SH’s income and not deductible by the corporation

   2. Redemption of shares (buys back) from a SH, entire amount taxed as a dividend if the SH or related persons continue to own stock in the corporation

2. Debt: borrowing money: bonds, notes, etc.

   1. No double tax: interest paid on corporate debt is includible in recipient’s income, but is deductible by the corporation

   2. Repayment of debt is tax-free return of capital, gain treated as capital gain

3. Example: X earns 100, pays out to A

   1. As interest, deductible by the corporation, 0 corporate tax

      1. 100 income to A

      2. A gets 60.4 after 39.4% income tax

   2. As dividend, corporations pays 35% corporate tax

      1. 100-100*35=65 dividends after tax

      2. 20% dividend tax on the 65 -65*20%= 52

4. Therefore, you prefer debt to equity.

5. Common law standards

   1. To prevent tax avoidance through the use of excessive debt, IRS may reclassify a purported debt obligation as equity.

   2. Common stock (risky, equity) preferred stock (in the middle, treated as equity) debt (safe)

      1. Preferred stock is preferred to common stock, with respect to liquidation proceeds and dividends

      2. Preferred stock is a stock, you get preference on dividends over common stock, if the corporation decides to pay dividends, up to the preference limit.

      3. The excess to the preference limit goes to common stock

      4. If the corporation liquidates, preferred stock gets payment second (after debt), up to the preference limit

      5. Payment treated as dividend, not deductible

6. Section 385

   1. Section 385(b) factors

      1. Form

         1. if you want it to be qualified by debt, it needs to have debt characteristics

         2. Debt instrument should have an unconditional promise to pay; a specific term; remedies for a default; stated, reasonable rate of interest, payable in all events

      2. Subordination to any indebtedness of the corporation

         1. If payment to outsider debt first, then SH’s debt looks like equity

      3. The debt/equity ratio

         1. High debt/equity ratio creates a substantial risk that what purports to be debt will be reclassified as equity

         2. Test: under similar circumstances, would a rational creditor would lend money to a corporation with such nominal equity? If no, then treat all the debt as equity

      4. Convertibility to stock

         1. If debt is convertible to stock, it’s more likely to be treated as equity

      5. Proportionality

         1. If debt held by the shareholders is in the same proportion as their stock holdings, debt may be treated as equity.

         2. Proportion calculation, choose the lesser of stock and debt of each SH and add them up.

            1. As proportion gets closer to 100%, the more likely debt may be treated as equity

2. 385(c)(1): classification made by the issuer is binding on the issuer and all holder of the instrument

7. Problem 1 on 142-43

Also 900 bank loan, prime+2, 10 years, secured

1. 300 loan from each SH, 5yr, prime -1,unsecured borderline

   1. Debt/equity ratio, four combinations possible

      1. Proposed regulation: use equity at basis

      2. Courts generally look at equity at value

         1. Inside+outside debt=1.8M

         2. Inside debt alone=0.9M

         3. Equity at book: 0.24M

         4. Equity at basis: 0.14M

   2. Subordination: insider debt is not secured, outside debt is secured

   3. Proportional: it is proportional

2. 20 yrs, subordinated income debentures recharacterized as equity

   1. Interest payable out of profit

   2. Subordinated

3. 900 loan from bank will be unsecured but personally guaranteed by A, B and C

   1. IRS: in economic reality, it’s a loan for the shareholders, not for the corporation. SH are deemed to contribute the loan proceeds to the corporation, therefore, considered capital contribution.

      1. When the corporation pays back the interest, then the corporation is paying interest for the SH,

         1. Bad for the corporation

            1. the corporation cannot get interest deduction

            2. the interest payment deemed as disguised dividends.

         2. Nothing bad happen to SH

            1. SH taxed for dividends

            2. SH gets to deduct the interest

      2. When the corporation pays back principal

         1. Bad for SH

            1. SH taxed for dividends

            2. No interest deduction for repayment of principal

         2. Nothing bad for corporation

            1. Not getting deduction for principal anyway.

      3. D/E ratio lower for the 300 each personal note

      4. IRS is not aggressive at all in pursuing this argument, only take this position in extremely egregious circumstances

4. If the insider debt of 900 comes from A.

   1. Proportion is now 33.33%, low proportion

5. Same as d. 2 years later, Corporation does not pay A because of cash flow problems

   1. This is a little like equity now because the interest payment is dependent on earnings of the corporation.

   2. A can argue that it is just giving the corporation some time to recover; instead of forcing the corporation to pay and bankrupt the corporation.

   3. Hindsight: What’s done in a later year is an evidence of what was intended...