Capital Structure Tx 8120. Learning Objectives 1.Compare tax consequences of using versus , 2.Determine ______ of losses from stock and

Capital StructureTx 8120

Learning Objectives

1. Compare tax consequences of using ____ versus ________,

2. Determine __________ of losses from stock and debt instruments, and

3. Explain when debt might be treated as _________.

You should be able to:

Fundamental Business Activities

Operations

Financing

Investments

Sources of Financing1) Creditors (____ financing)2) Earnings (______ financing)3) Owners (_______ financing)

Capital Structure Introduction

• Combination of debt and ______ a corporation uses to finance operations and ____________

• Many factors affect capital structure.– Risk of financial _______ (e.g.,

bankruptcy)– Debt ___________ effect (capital assets

can be used as _________)– Desire to retain _______

Capital Structure Issues

1. How much gain or loss do investors recognize when _________ property?

2. How much tax do investors incur from __________ returns?

3. How much and what type of gain do investors recognize from a corporation ____________ capital?

4. How much and what type of gain or loss do investors recognize from _________ their investments?

5. How much loss can investors deduct from their investments __________ worthless?

1. How much can corporations deduct when __________ returns on their capital?

2. How much penalty must corporations pay from unreasonably ____________ profit?

Investor Issues Corporation Issues

Raising Capital

Investor issue #1Contributing property

• With stock– Gain or loss deferred via §____– Assumes investor “________”

• With debt– Gain deferred via ___________ method unless

• Property consists of __________,• Property is __________ and transferee is related, or• Taxpayer ______ out

– Loss currently deductible

Compensating Individual Investors

• On equity capital– Dividends taxed at __% or ___%– Present value benefits if dividends ________– Exempt if shares held until _____

• On debt capital– Interest taxed as ________ income

Investor issue #2Receiving returns

Compensating Corporate Investors

• On equity capital– ____ reduces marginal tax rate

• On debt capital– Interest taxed as _________ income

Investor issue #2Receiving returns

Capital Backflow

• Assume _________ corporation• To equity investor

– Redemption often treated as _______

– Taxed at __% or ___%

• To debt investor– Tax-____ return of ________ for

principal– _______ _____ for any excess

Investor issue #3Returning capital

Sell Holding at Gain

• Debt investment generally results in _______ gain

• Equity investments– Generally results in _______ gain– Investors can exclude up to ____ the

gain on qualified small business stock held > __ years, §1202

Maximum investor’s MTR =

Investor issue #4Selling investment

Section 1202 Treatment

• Investor must be noncorporate, ______ holder.

• C corporation must:– Be ________ in United States,– Own < $___ million gross assets, and– Be engaged in qualified active business during

________ ____ of investor’s holding period.• Not own ________ ______ valued at > 10% of total

assets and

• Not own __________ stock and securities valued at > 10% of net assets


Sell Holding at Loss

• Individuals can only deduct capital losses to extent of ________ gains plus $3,000.

• Debt investment generally results in _______ loss when sold.

• Equity investment– Generally results in _________ loss– Losses on §1244 stock are ________ up to

$50,000 (or $_________ on joint return)


Section 1244 Treatment

• Investor must be:– _________ (or individual partners in partnership

owning §1244 stock) and– ___________ holder of stock

• Corporation must be:– _________ in United States,– ____ business corporation when stock issued, and– __________ company when investor sustains loss


Section 1244 Treatment(Small Business Corporation)

• Must qualify when stock is ______ (later qualification unnecessary)

• Total paid-in equity capital ≤ ___________– _____ plus– Other property (________ ______ less related

liability)


Section 1244 Treatment(Operating Company)

• Must qualify when investor ______ loss (earlier qualification unnecessary0

• Test period is ___ most recent taxable years ending prior to sustaining loss– Operating receipts > ___% of gross receipts– Unless deductions (other than DRD and NOL) >

______ income


Lost Capital

• Debt investments– __________ security is capital loss– Business ____ _____ is ordinary loss– ____________ bad debt is short-term capital loss

• Equity investments– Worthless stock (unless affiliate) is ______ loss– Worthless §1244 stock is __________ loss

Investor issue #5Becoming worthless

US v. Generes(S.Ct., 1972)

_______-______ (taxpayer) owned 44% of closely-held

construction corporation (original investment of $38,900) for

which he worked 6 to 8 hours each week (annual salary

$12,000). Taxpayer guaranteed corporate loans, later

indemnified corporation’s underwriter for loans in default,

and failed to receive _________ from the corporation. The

issue was whether the taxpayer’s bad debt was business or

nonbusiness in nature. If business, an ________ deduction

ensues. If nonbusiness, a _____________ results.


US v. Generes(S.Ct., 1972)

Examining whether the individual’s business motive was

__________, the D.Ct. and CA-5 held for the taxpayer (i.e.,

business bad debt). In _________, the S.Ct. formulated the

touchstone as the taxpayer’s _________ motive for the loan

guarantees. Did the guarantees protect his ________ (annual

pre-tax salary of $12,000) or _______ ($39,000 investment)?

The court decided the loss was a _________ bad debt.


Compensating Investors

• On equity investment– Dividends are distributions of _________– ___ corporate deduction

• On debt investment– Interest is expense of ________ operations and

investments– Corporate deduction reduces ____ of _______– ________ earnings from corporate level tax

Corporate issue #1Paying returns

Hording Capital

• Penalty of ___% applies to corporation’s “accumulated taxable income”

• Corporations can avoid penalty via _______ business needs, which include funds to:– Redeem _____ from decedent’s estate– ______ business indebtedness

Corporate issue #2Accumulating profit

Choosing Debt or Equity

1. How much can corporations deduct when _________ returns on their capital?

2. How much penalty must corporations pay from unreasonably _____________ profit?

Investor Issues Corporation Issues

1. How much gain or loss do investors recognize when __________ property?

2. How much tax do investors incur from ________ returns?

3. How much and what type of gain do investors recognize from a corporation ___________ capital?

4. How much and what type of gain or loss do investors recognize from _______ their investments?

5. How much loss can investors deduct from their investments _________ worthless?

Section 385(c)

(c) Effect of classification by issuer.

(1) In general. The characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary).

Distinguishing debt from equity

CIR v. O.P.P. Holding Corp.(CA-2, 1935)

The “shareholder is an adventurer in the corporate

business; he takes the ____, and profits from success. The

creditor, in compensation for not sharing the profits, is to

be paid independently of the ____ of success, and gets a

right to dip into ________ when the payment date arrives.”


Slappey Drive Industrial Park v. US(CA-5, 1977)

A family of closely-held real estate corporations

received capital from shareholders in several

transactions outwardly structured as unsecured credit

purchases of acreage or unsecured loans. In each

situation, corporations failed to _____ principal and

interest per the agreed schedule. The common president

of each corporation testified that the shareholders never

objected because they were more concerned about their

_______ investment and that corporations made

payments when _____ became available.


Slappey Drive Industrial Park v. US(CA-5, 1977)

Noting 13 Mixon criteria, the court reaffirmed that all

factors are not weighted equally and that each case is

____ specific. In contrast to normal creditor-debtor

arrangements, the shareholders seemed to be placing

their capital “at the prolonged _____ of the business.”

Some imperfect proportionality between debt and equity

holdings did not sway the court in light of _____ ______

holding all shares. Also, some adequate debt-equity

____ were not persuasive alone. The court held that all

instruments at issue involved _____, not debt, capital.


Fin Hay Realty Co. v. US(CA-3, 1968)

Two 50% shareholders made unsecured loans to their

corporation in equal amounts, taking back _______

promissory notes. The corporation used the loan proceeds to

invest in apartment buildings. The IRS later disallowed

“_______” deductions, asserting the notes represented _____

interests. The District Court held for the IRS.


Fin Hay Realty Co. v. US(CA-3, 1968)

In siding with the gov’t, the court noted that the corporation

could not have obtained outside mortgage financing in 1934

on similar terms. A “prudent outside businessman” would not

have made such loans. Further, the “______” nature of the

loan was not an ___ _____ characterization since the

corporation invested the proceeds in apartments and, thus,

could not have repaid the loans for many years. Also, holding

“____” in proportion to shareholdings smelled of an ______

investment. In short, the form of the corporate advance did

not match its ________ _________.


Telltale Signals

• Missing _______ of debt

• _____ debt-to-equity ratio (e.g., inside > ____)

• Debt held in ______ proportion as equity

• ___ paying principal and interest as scheduled

• _______ securities such as debt instruments– __________ into equity– Entitled to ____– Paying interest ____ ___ earnings or cash adequate


Treating Debt as Stock

• Recharacterization of debt as equity can be catastrophic– Deductible interest reclassified as

________– Repayment of principal treated as

________

• Especially affects _________ corporations


Dine,Inc.

A

B

C

Cash $80,000

Building: FMV $80,000 Basis 20,000

Cash $40,000Goodwill: FMV 40,000 Basis 0

100 common shares

100 common shares

100 common shares

A, B, and C form Dine, Inc. to operate a restaurant that C previously operated as a sole proprietorship. After the initial contribution (see diagram), Dine needs $1.8 million more capital to renovate the building, acquire equipment, and provide working capital. So, Dine obtains a $900,000 loan from bank: interest payable at two points above prime rate as determined semi-annually, principal due in 10 years, and renovated building securing the loan. The remaining $900,000 capital will come from shareholder loans.

Adjusted Basis FMVCash $1,920,000 $1,920,000Building 20,000 80,000Goodwill 0 40,000

$1,940,000 $2,040,000

Bank loan $ 900,000Shareholder loans 900,000Common stock 240,000

$2,040,000

Lind et al., pp. 146-47


$1,940,000 $2,040,000


$2,040,000

Proposal 1: A, B, and C each loan Dine $300,000, taking back 5-year notes with variable interest payable at one point below prime as determined annually.

Positive Aspects Negative Aspects



$1,940,000 $2,040,000


$2,040,000

• Determining debt• Ignore ___ to trade creditors• Calculate with:

• ______ debt only or• _______ debt too

• Determining equity• Use ______ ______ of assets or• Use ____ of assets• Subtract _____ in either case

Inside debt to equity (basis)

Inside debt to equity (FMV)

Total debt to equity (basis)

Total debt to equity (FMV)



$1,940,000 $2,040,000


$2,040,000

Proposal 2: A, B, and C each loan Dine $300,000, taking back 20-year, 10% subordinated income debentures (i.e., interest payable only out of net profits).




$1,940,000 $2,040,000


$2,040,000

Proposal 3: A, B, and C each loan Dine $300,000, taking back 5-year notes with variable interest payable at one point below prime. But, owners personally guarantee bank loan, which is unsecured.




$1,940,000 $2,040,000


$2,040,000

Proposal 4: A loans Dine $900,000, taking back 5-year notes with variable interest. But, Dine has cash flow problems and pays interest only the first two years.



Documents

Capital Structure Tx 8120. Learning Objectives 1.Compare tax consequences of using ____ versus ________, 2.Determine __________ of losses from stock and

Capital Structure Tx 8120. Learning Objectives 1.Compare tax consequences of using versus , 2.Determine ______ of losses from stock and