1. 1 CORPORATE TAXATION I Today Today Revisit Problem 1 on page 99Revisit Problem 1 on page 99 Debt v. EquityDebt v. Equity Fin Hay Realty Co. v. United StatesFin Hay Realty Co. v. United States Problems on page 146Problems on page 146 United States v. GeneresUnited States v. Generes Problems on page 157Problems on page 157

2. 2 Debt v. Equity Why is there still a preference for Debt over Equity? Why is there still a preference for Debt over Equity? Repayment of principal is tax freeRepayment of principal is tax free Interest on the principal is tax deductible to the corporationInterest on the principal is tax deductible to the corporation

3. 3 Fin Hay Realty Co. v. United States Facts: Facts: Two shareholders incorporated a business making a capital contribution of $10K each and loaned the corporation $15K each. The note was a demand note bearing interest of 6% per annum (used to purchase an apartment buildings for $35K in cash)Two shareholders incorporated a business making a capital contribution of $10K each and loaned the corporation $15K each. The note was a demand note bearing interest of 6% per annum (used to purchase an apartment buildings for $35K in cash) One month later, each advanced an additional $35K on the same terms as the original note (used to purchase two apartment buildings for $75K in cash and a $100K of 5- year mortgage at 6% per year)One month later, each advanced an additional $35K on the same terms as the original note (used to purchase two apartment buildings for $75K in cash and a $100K of 5- year mortgage at 6% per year) Three years later, they refinanced the buildings at 4.5% per annumThree years later, they refinanced the buildings at 4.5% per annum Over the following 3-years, they each advanced an additional $3K eachOver the following 3-years, they each advanced an additional $3K each

4. 4 Fin Hay Realty Co. v. United States Issue: Were the “advances” to the corporation really just disguised capital contributions? Issue: Were the “advances” to the corporation really just disguised capital contributions? Ruling: Yes. Ruling: Yes. The court noted sixteen factors used by courts and commentators to determine the “economic reality” of the transaction (inherently a factual determination): The court noted sixteen factors used by courts and commentators to determine the “economic reality” of the transaction (inherently a factual determination): (1) the intent of the parties(1) the intent of the parties (2) the identity between creditors and shareholders(2) the identity between creditors and shareholders (3) the extent of participation in management by the holder of the instrument(3) the extent of participation in management by the holder of the instrument (4) the ability of the corporation to obtain funds from outside sources(4) the ability of the corporation to obtain funds from outside sources (5) the "thinness" of the capital structure in relation to debt(5) the "thinness" of the capital structure in relation to debt (6) the risk involved(6) the risk involved (7) the formal indicia of the arrangement(7) the formal indicia of the arrangement (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal(8) the relative position of the obligees as to other creditors regarding the payment of interest and principal

5. 5 Fin Hay Realty Co. v. United States The Sixteen factors (continued) The Sixteen factors (continued) (9) the voting power of the holder of the instrument(9) the voting power of the holder of the instrument (10) the provision of a fixed rate of interest(10) the provision of a fixed rate of interest (11) a contingency on the obligation to repay(11) a contingency on the obligation to repay (12) the source of the interest payments(12) the source of the interest payments (13) the presence or absence of a fixed maturity date(13) the presence or absence of a fixed maturity date (14) a provision for redemption by the corporation(14) a provision for redemption by the corporation (15) a provision for redemption at the option of the holder(15) a provision for redemption at the option of the holder (16) the timing of the advance with reference to the organization of the corporation(16) the timing of the advance with reference to the organization of the corporation

6. 6 Problems on Page 146 Problem 1 Problem 1 A, B & C each contribute $80K in assets in exchange for 1/3 of the stock in Chez Guevara, Inc.A, B & C each contribute $80K in assets in exchange for 1/3 of the stock in Chez Guevara, Inc. Chez Guevara requires at least $1.8MM in additional capital, of which it has negotiated a loan for ½ (i.e. $900K) from the bank on the following terms:Chez Guevara requires at least $1.8MM in additional capital, of which it has negotiated a loan for ½ (i.e. $900K) from the bank on the following terms: Interest = 2pts above prime Interest = 2pts above prime Term = 10-years Term = 10-years Security = the renovated building Security = the renovated building Proposal 1(a) Proposal 1(a) Each loans $300K at 1pt below prime and a variable interest rateEach loans $300K at 1pt below prime and a variable interest rate Factors to consider: Factors to consider: Form of the obligation (was the debt form properly maintained?)Form of the obligation (was the debt form properly maintained?) Proportionality (Important to address)Proportionality (Important to address) Amount of Debt relative to equityAmount of Debt relative to equity Intent (Lesser importance)Intent (Lesser importance) Proposal 1(b) Proposal 1(b) Each loans $300K of 10%, 20-year income debenture (interest payable out of the income of the business only)Each loans $300K of 10%, 20-year income debenture (interest payable out of the income of the business only) Same factors, but far more problematic Same factors, but far more problematic

7. 7 Problems on Page 146 Problem 1 (con’t) Problem 1 (con’t) Proposal 1(c)Proposal 1(c) Same as 1(a) (i.e. each loans $300K at 1pt below prime and a variable interest rate). In addition, each shall personally guarantee the loan from the bank (which is now unsecured) and shall be jointly and severally liable for its repayment Same as 1(a) (i.e. each loans $300K at 1pt below prime and a variable interest rate). In addition, each shall personally guarantee the loan from the bank (which is now unsecured) and shall be jointly and severally liable for its repayment Same analysis as 1(a), except that now the bank loan becomes “suspect”. In addition, if the bank loan is viewed as shareholder debt it increases the debt ratio (i.e. the debt to equity ratio), making a ruling that both the bank and the shareholder debt is really equity.Same analysis as 1(a), except that now the bank loan becomes “suspect”. In addition, if the bank loan is viewed as shareholder debt it increases the debt ratio (i.e. the debt to equity ratio), making a ruling that both the bank and the shareholder debt is really equity. Proposal 1(d)Proposal 1(d) A will loan the additional $900K at 1pt below prime and a variable interest rate in exchange for a corporate note A will loan the additional $900K at 1pt below prime and a variable interest rate in exchange for a corporate note Probably not disguised equity, since it lack proportionalityProbably not disguised equity, since it lack proportionality Proposal 1(e)Proposal 1(e) Same as previous, except that two years after getting the note, Chez Guevara ceases to pay interest on the notes because of cash flow problems Same as previous, except that two years after getting the note, Chez Guevara ceases to pay interest on the notes because of cash flow problems Failure to pay interest when due, raises the possibility of reclassification after the factFailure to pay interest when due, raises the possibility of reclassification after the fact

8. 8 Problems on Page 146 Problem 2 Problem 2 DiscussionDiscussion

9. 9 United States v. Generes Facts: Taxpayer made a loan to a corporation owned by his son and himself. The Taxpayer, who was president of the corporation, was only a part-time employee, but also held down other positions and did not spend more than 6-8 hours per week at the corporate offices and received less than 50% of his total income from the corporation. Facts: Taxpayer made a loan to a corporation owned by his son and himself. The Taxpayer, who was president of the corporation, was only a part-time employee, but also held down other positions and did not spend more than 6-8 hours per week at the corporate offices and received less than 50% of his total income from the corporation. Issue: Were the loans to the corporation sufficiently related to the Taxpayer’s employment at the company to make them business loans or were they more related to his interest as a shareholder which results in non-business debt (and eliminates the Taxpayer’s ability to take them as business bad debt when they went unpaid. Issue: Were the loans to the corporation sufficiently related to the Taxpayer’s employment at the company to make them business loans or were they more related to his interest as a shareholder which results in non-business debt (and eliminates the Taxpayer’s ability to take them as business bad debt when they went unpaid. Ruling: In order for a debt to have a proximate relation to the taxpayer’s trade or business (i.e. to be a “business” debt for purposes of §166), the Taxpayer’s trade or business motivation for the debt must be dominant. Ruling: In order for a debt to have a proximate relation to the taxpayer’s trade or business (i.e. to be a “business” debt for purposes of §166), the Taxpayer’s trade or business motivation for the debt must be dominant. Aftermath of US v. Generes is that any shareholder debt is treated as non-business debt, regardless of the taxpayer’s position within the company. Aftermath of US v. Generes is that any shareholder debt is treated as non-business debt, regardless of the taxpayer’s position within the company.

10. 10 Problems on Page 157 Problem 1 Problem 1 Proposal 1(a)Proposal 1(a) Fails to accomplish her investment goals because she does not participate in the success of the company (i.e. no equity piece) and may or may not give her an advantageous position in the case of a bankruptcy, since we do not know if Jennifer is engaged in the “business” of lending money. Fails to accomplish her investment goals because she does not participate in the success of the company (i.e. no equity piece) and may or may not give her an advantageous position in the case of a bankruptcy, since we do not know if Jennifer is engaged in the “business” of lending money. Proposal 1(b)Proposal 1(b) A registered bond is a “security” instrument under §165 and would provide a long-term capital loss if held for more than one year. It still would not allow any participation in the company if successful (i.e. no equity interest) A registered bond is a “security” instrument under §165 and would provide a long-term capital loss if held for more than one year. It still would not allow any participation in the company if successful (i.e. no equity interest) Proposal 1(c)Proposal 1(c) Same result at 1(b) with the additional ability for her to participate in the success of the company. Same result at 1(b) with the additional ability for her to participate in the success of the company.

11. 11 Problems on Page 157 Problem 1 Problem 1 Proposal 1(d)Proposal 1(d) If the stock qualifies for treatment as §1244 stock, then she can treat up to $50K ($100K if she is married filing jointly) as an ordinary loss. The residual would be treated as a capital loss (long-term, if she holds it more than one-year) If the stock qualifies for treatment as §1244 stock, then she can treat up to $50K ($100K if she is married filing jointly) as an ordinary loss. The residual would be treated as a capital loss (long-term, if she holds it more than one-year) Proposal 1(e)Proposal 1(e) Same as 1(d) Same as 1(d) Proposal 1(f)Proposal 1(f) Since the corporation does not meet the “small business” requirements of §1244 (i.e. has more than $1MM of capital contribution in exchange for stock), any loss would be capital in nature Since the corporation does not meet the “small business” requirements of §1244 (i.e. has more than $1MM of capital contribution in exchange for stock), any loss would be capital in nature Proposal 1(g)Proposal 1(g) Treatment of loss on §1244 stock is only available to the original recipient. The subsequent transfer would eliminate any benefits that she might otherwise receive Treatment of loss on §1244 stock is only available to the original recipient. The subsequent transfer would eliminate any benefits that she might otherwise receive Proposal 1(h)Proposal 1(h) Provided that the partnership retains the stock and the loss flows through to the individual partners, each can take the $50K ordinarily income loss. If the partnership distributes the shares to the partners, then the §1244 treatment would be lost. Provided that the partnership retains the stock and the loss flows through to the individual partners, each can take the $50K ordinarily income loss. If the partnership distributes the shares to the partners, then the §1244 treatment would be lost.