Capital Structure

Tx 8120
 Learning Objectives

You should be able to:

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
_________.
 Fundamental Business Activities

Operations Investments

Financing

Sources of Financing
1) 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
Investor Issues Corporation Issues
1. How much gain or loss do investors 1. How much can corporations deduct when
recognize when _________ property? __________ returns on their capital?

2. How much tax do investors incur from 2. How much penalty must corporations pay
__________ returns? from unreasonably ____________ profit?

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?
Investor issue #1
Contributing property

Raising Capital
• 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
Investor issue #2
Receiving returns

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 #2
Receiving returns

Compensating Corporate Investors

• On equity capital
– ____ reduces marginal tax rate
• On debt capital
– Interest taxed as _________ income
Investor issue #3
Returning capital

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 #4
Selling investment

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 #4
Selling 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
Investor issue #4
Selling investment

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)
Investor issue #4
Selling investment

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
Investor issue #4
Selling investment

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)
Investor issue #4
Selling investment

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
Investor issue #5
Becoming worthless

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 #5
Becoming 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.
Investor issue #5
Becoming worthless

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.
Corporate issue #1
Paying returns

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 #2
Accumulating profit

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
 Choosing Debt or Equity
Investor Issues Corporation Issues
1. How much gain or loss do investors 1. How much can corporations deduct when
recognize when __________ _________ returns on their capital?
property?
2. How much penalty must corporations pay
2. How much tax do investors incur from from unreasonably _____________
________ returns? profit?

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?
Distinguishing debt from equity

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.”
Distinguishing debt from equity

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.
Distinguishing debt from equity

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.
Distinguishing debt from equity

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.
Distinguishing debt from equity

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 ________ _________.
Distinguishing debt from equity

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
Distinguishing debt from equity

Treating Debt as Stock

• Recharacterization of debt as
equity can be catastrophic
– Deductible interest reclassified as
________
– Repayment of principal treated as
________
• Especially affects _________
corporations
 Lind et al., pp. 146-47
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 FMV

Cash $1,920,000 $1,920,000
Cash $80,000 Building 20,000 80,000
A 100 common shares Goodwill 0 40,000
$1,940,000 $2,040,000

Bank loan $ 900,000

Building: FMV $80,000 Shareholder loans 900,000
Basis 20,000 Dine, Common stock 240,000
B 100 common shares Inc. $2,040,000

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

C 100 common shares

 Lind et al., pp. 146-47
Adjusted Basis FMV
Cash $1,920,000 $1,920,000
Building 20,000 80,000
Goodwill 0 40,000 Proposal 1: A, B, and C each loan
$1,940,000 $2,040,000 Dine $300,000, taking back 5-
Bank loan $ 900,000 year notes with variable interest
Shareholder loans 900,000 payable at one point below prime
Common stock 240,000
$2,040,000 as determined annually.

Positive Aspects Negative Aspects

 Lind et al., pp. 146-47
Adjusted Basis FMV
Cash $1,920,000 $1,920,000
Building 20,000 80,000 Inside debt to equity (basis)
Goodwill 0 40,000
$1,940,000 $2,040,000

Bank loan $ 900,000

Shareholder loans 900,000
Common stock 240,000 Inside debt to equity (FMV)
$2,040,000

• Determining debt
• Ignore ___ to trade creditors Total debt to equity (basis)
• Calculate with:
• ______ debt only or
• _______ debt too

• Determining equity Total debt to equity (FMV)

• Use ______ ______ of assets or
• Use ____ of assets
• Subtract _____ in either case
 Lind et al., pp. 146-47
Adjusted Basis FMV
Cash $1,920,000 $1,920,000
Building 20,000 80,000
Goodwill 0 40,000 Proposal 2: A, B, and C each loan
$1,940,000 $2,040,000 Dine $300,000, taking back 20-
Bank loan $ 900,000 year, 10% subordinated income
Shareholder loans 900,000 debentures (i.e., interest payable
Common stock 240,000
$2,040,000 only out of net profits).

Positive Aspects Negative Aspects

 Lind et al., pp. 146-47
Adjusted Basis FMV
Cash $1,920,000 $1,920,000
Building 20,000 80,000 Proposal 3: A, B, and C each loan
Goodwill 0 40,000
$1,940,000 $2,040,000 Dine $300,000, taking back 5-
year notes with variable interest
Bank loan $ 900,000
Shareholder loans 900,000 payable at one point below prime.
Common stock 240,000 But, owners personally guarantee
$2,040,000
bank loan, which is unsecured.

Positive Aspects Negative Aspects

 Lind et al., pp. 146-47
Adjusted Basis FMV
Cash $1,920,000 $1,920,000
Building 20,000 80,000
Goodwill 0 40,000 Proposal 4: A loans Dine
$1,940,000 $2,040,000 $900,000, taking back 5-year
Bank loan $ 900,000 notes with variable interest. But,
Shareholder loans 900,000 Dine has cash flow problems and
Common stock 240,000
$2,040,000 pays interest only the first two
years.
Positive Aspects Negative Aspects