Issuing third-party debt to raise additional capital.

In many cases, a corporation reaps tax advantages if it issues debt, rather than stock, to investors, because interest paid on the corporation's debt is deductible, while dividends paid to shareholders are not. Further, the creditor receives principal repayments on corporate debt tax free, while distributions to shareholders are normally taxable as dividends to the extent of earnings and profits. The bias for issuing corporate debt and against capitalizing the corporation with equity (i.e., stock) has not changed due to recent legislation. (When it is not possible to use debt due to business reasons, the disadvantage of using equity is reduced, because qualified dividend income is currently taxed at a maximum 15% rate.)

If third-party debt is used as part of the initial capital structure, the shareholders do not need to invest as much of their personal funds, but can still obtain the same amount of ownership and control. Because less of the shareholders' money is invested, there is less likelihood they will need to take cash withdrawals that might be dividends to them and nondeductible by the corporation. The third-party loans can be repaid with cashflow generated by the business. Also, these repayments will not affect the shareholders' ownership interests and voting rights.

Example 1

Mary Jones contributed $100,000 to her new corporation, MJ Inc. The corporation borrowed an additional $200,000 in capital from Mary's friend, Stan Smith, to operate the business. Stan insisted on a market interest rate of 8% and monthly payments that will result in full repayment over 10 years.

Even though MJ incurred substantial interest expense over the 10-year period, it was able to fully repay the $200,000 debt. By leveraging capital with outside debt, the shareholder's rate of return on capital exceeded the 8% interest rate paid on the borrowed funds. Mary now owns 100% of all MJ's stock, with a personal investment of only $100,000. This option is clearly preferable to providing other individuals with stock that has voting rights or dividend preferences. Of course, the difficulty lies in finding an outside party willing to loan funds to a start-up company.

Outside investors holding corporate debt and equity have the advantage of being creditors in the case of bankruptcy or liquidation, while still maintaining an equity interest in case the venture is successful. Shareholder-creditors are on an equal footing with other creditors if the corporation goes bankrupt; however, shareholders will receive liquidating proceeds only after the creditors' claims have been met.

Example 2

Mary and Rich plan to establish a corporation to manufacture furniture. They will need $120,000 to capitalize it; however, they have only $21,000 to invest. They want to retain management control and a large portion of the profits, but realize that most investors will demand common stock in exchange for at least part of their contributions. The corporation could issue 51% of the common stock to Mary and Rich in exchange for their $21,000. Assuming a common stock par value of $100, Mary and Rich could receive 210 shares of common stock. The outside investors would then be allowed to purchase the remaining 49% of the common stock only if they also contribute cash for debt securities.

The outside investors would receive 200 shares of common stock for $20,000 and contribute $80,000 for the corporation's debt securities. This would give the organizers the $120,000 needed to capitalize the venture, while allowing them to retain 51% (210/(210 + 200)) of the voting power and equity participation.

Although the securities the outside investors receive will be deemed boot, they will not recognize any gain on the transaction, because recognized gain is limited to the lesser of boot received or gain realized. Because cash is being transferred in exchange for securities whose value equals the amount of cash transferred, they recognize zero gain.

Alternatively, the corporation could issue preferred stock as an added incentive to investors. However, issuing preferred stock in place of either the debt or the common stock would probably not entice an investor to put a significant amount of capital into the corporation.

Because corporate debt in reality may be disguised equity to achieve better tax results, the IRS might treat debt securities issued by the corporation as equity for tax purposes. Over the years, the IRS and the courts have looked beyond the face of a debt instrument--particularly in connection with loans to shareholders--to determine the true substance of an obligation. In many situations, the courts have held that debt is actually disguised equity and required it to be reclassified as such.

Strategy

Using third-party debt can help avoid this result. Because such debt instruments are normally negotiated at arms' length, the debt-versus-equity question is not as critical as with shareholder debt. A third-party investor will normally insist on a bona-fide debt instrument, market interest rate and regular payments, thereby nullifying most of the points indicating disguised equity arrangements. To ensure that the debt to the outside investors is not reclassified as equity for income tax purposes, it should be properly substantiated as such. A written promissory note should be drawn up, and a repayment schedule should be specified and followed.

Care should be taken to ensure such third-party debt is owed directly by the corporation, rather than personally by the shareholders. If owed by the shareholders, the corporation may have to withdraw funds to make debt repayments, potentially resulting in dividend distributions that are taxable to the shareholders and nondeductible by the corporation. Alternatively, shareholders can loan the funds to the corporation. Then the corporation can make loan repayments to the shareholders, which they can use to repay their personal debt. However, the overall debt-to-equity ratio of the corporation must be considered. Also, the shareholders will realize interest income on the corporate debt repayments, but may not be able to fully deduct the investment interest they will pay on the personal debt.

Editor's note: This case study has been adapted from PPC's Tax Planning Guide--Closely Held Corporations, 191h Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Kellie J. Bushwar and Lisa A. Lachmann, published by Practitioners Publishing Company, Fort Worth, TX, 2005 ([phone]; ppc.thomson.com).

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, VA