Small business tax solutions.

This series is based on questions from AICPA tax certificate of educational achievement (CEA) courses.

Q. When a corporation expands--through acquisition or internal growth--it often needs to borrow money to fund this expansion. Are there any limitations on the deductibility of interest under these circumstances?

A. Debt must clear at least four hurdles to ensure the interest is deductible:

1. The borrowing instrument must be debt, not equity.

2. Internal Revenue Code section 163(e)(5), the test for high-yield debt instruments, must be avoided.

3. IRC section 279--on subordinated acquisition debt--must be avoided.

4. IRC section 163(j)--debt borrowed from tax-exempt related parties--must be avoided.

DEBT OR EQUITY?

The first hurdle ensures the borrowing is treated as debt under both IRC section 385, which sets forth debt-equity rules, and the common law precedent of distinguishing debt from equity. While no brief discussion can analyze all factors, ultimately tile proper characterization looks to tile existence of typical debt characteristics such as a fixed maturity date, a fixed or determinable interest rate and typical creditor remedies, such as foreclosure. The absence of equity features such as voting rights and the right to participate in corporate growth are also considered.

HIGH-YIELD DEBT

The second hurdle is section 163(e)(5), which, if applicable, defers tile interest deduction until the interest is paid (although the holder still accrues income).

Section 163(e)(5) applies if the

* Borrower is a C corporation.

* Maturity exceeds five years (including extension options).

* Yield to maturity, calculated under the original issue discount (OLD) rules, equals or exceeds the applicable federal rate (AFR) plus 5%.

* Debt has significant OID.

The first three tests are mechanical; the fourth is more complicated but requires all interest except the first year accrual to be brought current (paid in cash) within five years plus one accrual period of die debt (five and one-half years on a debt with semiannual compounding), and to remain current.

If section 163(e)(5) applies and the interest rate exceeds the AFR plus 6%, then part of the interest is treated as a dividend and is permanently disallowed. Note that the holder still accrues this income but it could qualify for the dividends-received deduction.

ACQUISITION DEBT

The first two limitations apply to any debt; the third, section 279, applies to debt used to fund acquisitions. Section 279 has six tests:

1. The borrower is a C corporation.

2. The debt is used to fund an acquisition.

3. The debt is subordinated to a substantial amount of unsecured debt.

4. The debt is issued with warrants or is convertible.

5. The entity fails a debt-equity or interest coverage test.

6. The borrower's aggregate interest for the. year exceeds $5 million.

Most of these tests are mechanical. Section 279 can thus be avoided by structuring around them. For example, issuing debt with common stock rather than warrants beats test 4. Using structural subordination (putting the senior debt in an operating subsidiary and junior debt in a holding company) fails the subordination requirement.

If a transaction fails section 279, the interest deduction on the acquisition debt is denied to the extent the corporation's total interest deductions exceed $5 million.

TAX EXEMPT RELATED PARTIES

Section 163(j) is applicable if the

1. Borrower is a C corporation.

2. Borrower has greater than a 1.5 to 1 debt-to-equity ratio.

3. Lender is more than 50% related (through ownership) to the borrower.

4. Lender is not subject to tax on the interest.

5. Borrower's total interest expense exceeds 50% of its earnings before interest, taxes, depreciation and amortization.

Because section 163(j) applies when the lender owns more than 50% of the borrower, the lender might be convinced to take a lesser equity stake because of the effect on the interest deduction. When the equity ownership is represented by warrants, ownership percentages might be traded by lowering the warrant's exercise price. If section 163(j) is a concern, the lender might be shown that avoiding the deferral results in a higher investment value due to the tax savings, making a lower equity percentage in everyone's best interest.

Section 163(j) applies only if the lender is tax exempt, including limited partnerships with pension fund or other exempt partners, as well as foreign owners.

BRYAN E. BLOOM is a tax attorney with WRH Partners in Morristown, N.J.