C12-Chp-04-1C-Extra Debt Items-2012

C12-Chp-04-1C-Extra Debt Items-2012 - Chapter 4C Extra Debt...

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Unformatted text preview: Chapter 4C. Extra Debt Materials Edited December 31, 2010 Contents of next few slides Background on Debt and Equity Debt vs. Equity Thin corporations When you may have a debt vs. equity argument with the IRS. Criteria for Debt Earnings Stripping (Read on.) Debt vs. Equity Debt Corporation pays interest to debt holder which is deductible by corporation Interest paid is taxable as ordinary income to individual or corporate recipient (Temporary law provides that individuals use capital gains rates for dividend income.) Loan repayments are not taxable to investors unless repayments exceed basis Debt vs. Equity • Equity: – Corporation pays dividends which are not deductible – Taxable as ordinary income to recipient to extent corp has E & P • Corporate shareholder may receive dividends received deduction Reclassification of Debt As Equity If corp is “thinly capitalized”, i.e., has too much debt and too little equity IRS may argue that debt is really equity and deny tax advantages of debt financing If debt has too many features of stock, principal and interest payments may be treated as dividends Thin Capitalization Factors-1 • Debt instrument documentation • Debt terms (e.g., reasonable rate of interest and definite maturity date) • Timeliness of repayment of debt • Whether payments are contingent on earnings Thin Capitalization Factors-2 • Subordination of debt to other liabilities • Whether debt and stock holdings are proportionate • Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) • Debt to equity ratio Reclassification of Debt As Equity Four times for dispute: • Investment of assets in a corporation and receipt of stock or debt (351) vs. sale (Rudolph A. Hardman) • Does the investor receive dividends or interest? • Is corporation paying interest or dividend? • At the end, how is repayment or worthlessness treated? Debt or Equity? There is no definition in Code or regs for determining if an interest in a corp. is debt or equity. Characterization as debt or equity is based on case law: numerous factors identify economic substance of an investor's interest. Sec. 1361(c)(5)(B) Straight debt defined… any written unconditional promise to pay on demand or on a specified date a sum certain in money if — (i) the interest rate (and interest payment dates) are not contingent on profits, the borrower's discretion, or similar factors, (ii) there is no convertibility (directly or indirectly) into stock… Classification Criteria Item Stock Debt Interest or Dividends? Div. if Declared Interest must be paid Principal Repayment? No Maturity Must be paid at Maturity Payment Deductible? No Yes Type of Income? Div- Low Rate Int. - Ordinary Income Income Reported? If from E&P In all cases Count as Control-351? Yes No Profit Potential Unlimited Limited-Stated Interest Control over Mgt Elect Directors Generally, None Risk of loss Greater Less Earnings Stripping....
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This note was uploaded on 03/09/2012 for the course ACCT 6120 taught by Professor Godfrey,h during the Spring '08 term at UNC Charlotte.

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C12-Chp-04-1C-Extra Debt Items-2012 - Chapter 4C Extra Debt...

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