Interest on debt paid to debt hold is deductible by

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Interest on debt paid to debt hold is deductible by the corporation (unlike dividends) o Loan repayments are not taxable to investors unless the repayments exceed basis o Interest paid is taxable as ordinary income to individual or corporate recipient Equity in Capital Structure o Corporation pays dividends which are not deductible (taxable to individuals at low cap gains rates) o Corporate SH may receive dividends received deduction § 385 - Reclassification of Debt as Equity o Thin capitalization = shareholder debt is high relative to shareholder equity. IRS amy argue that debt is really equity and deny tax advantages of debt financing
If debt has too many features of stock, principal and interest pmts treated as dividends Thin Caitalization Factors o Debt instrument documentation documentation o Debt terms (reasonable rate of interest and definitely maturity date) o Timeliness of repayment of debt o Whether payments are contingent on earnings o Subordination of debt to other liabilities o Whether debt and stock holdings are proportionate o Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) o Debt to equity ratio IRS also has the authority to classify an instrument either as wholly debt or equity or as part debt and part equity Investor Losses o Stock & security losses: if stocks & bonds are capital assets, losses from worthlessness are capital losses Loss treated as occuring on the last day of tax year when they become worthless. No loss for mere decline in value o Stock & security losses: if stocks & bonds NOT capital assets, losses from worthlessness are ordinary losses Sometimes ordinary loss allowed for worthlessness of stock of affiliated company o Business vs nonbusiness bad debts Losses on debt of corp treated as business or nonbusiness bad debt If noncorporate person lends as investment, loss = nonbusiness bad debt ST cap loss. Only deductible when fully worthless If corporation is a lender, loss = business bad debt Ordinary loss deduction, deduction allowed for partial worthlessness, all bad debts of corporate lender qualify as business bad debt Noncorporate lender may qualify for business bad debt treatment if: Loan made in some capacity that qualifies trade or business or SH is in business of lending money or of buying, promoting, and selling corporations Section 1244 Stock o § 1244 permits ordinary loss treatment for losses on the sale or worthlessness of stock of so-called small business corporation o Gain is still capital gain o Applies to first $1m of corp’s stock If > $1m of stock issued, entity designates which shares qualify for 1244 treatment Property received in exchange for stock is valued at its adjusted basis, reduced by any liabilities assumed by the corporation or to which the property is subject FMV not considered o Annual loss limitation: 50k or 100k MFJ Any remaining loss is capital loss o

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