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Interest on debt paid to debt hold is deductible by the corporation (unlike dividends)oLoan repayments are not taxable to investors unless the repayments exceed basisoInterest paid is taxable as ordinary income to individual or corporate recipientEquity in Capital StructureoCorporation pays dividends which are not deductible (taxable to individuals at low cap gains rates)oCorporate SH may receive dividends received deduction§ 385 - Reclassification of Debt as EquityoThin 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 dividendsThin Caitalization FactorsoDebt instrument documentation documentationoDebt terms (reasonable rate of interest and definitely maturity date)oTimeliness of repayment of debtoWhether payments are contingent on earningsoSubordination of debt to other liabilitiesoWhether debt and stock holdings are proportionateoUse of funds (if used to finance initial operations or to acquire capital assets, looks like equity)oDebt to equity ratioIRS also has the authority to classify an instrument either as wholly debt or equity or as part debt and part equityInvestor LossesoStock & security losses: if stocks & bonds are capital assets, losses from worthlessness are capital lossesLoss treated as occuring on the last day of tax year when they become worthless.No loss for mere decline in valueoStock & security losses: if stocks & bonds NOT capital assets, losses from worthlessness are ordinary lossesSometimes ordinary loss allowed for worthlessness of stock of affiliated companyoBusiness vs nonbusiness bad debtsLosses on debt of corp treated as business or nonbusiness bad debtIf noncorporate person lends as investment, loss = nonbusiness bad debtST cap loss. Only deductible when fully worthlessIf corporation is a lender, loss = business bad debtOrdinary loss deduction, deduction allowed for partial worthlessness, all bad debts of corporate lender qualify as business bad debtNoncorporate 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 corporationsSection 1244 Stocko§ 1244 permits ordinary loss treatment for losses on the sale or worthlessness of stock of so-called small business corporationoGain is still capital gainoApplies to first $1m of corp’s stockIf > $1m of stock issued, entity designates which shares qualify for 1244 treatmentProperty 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 subjectFMV not consideredoAnnual loss limitation:50k or 100k MFJAny remaining loss is capital losso