Capital Structure Tx 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 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 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 IssuesCorporation Issues

Raising Capital Investor issue #1 Contributing 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 #2 Receiving returns

Compensating Corporate Investors On equity capital –____ reduces marginal tax rate On debt capital –Interest taxed as _________ income Investor issue #2 Receiving 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 #3 Returning 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 #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 #4 Selling investment

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. Investor issue #5 Becoming worthless

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 #1 Paying 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 #2 Accumulating 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 IssuesCorporation 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.” 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 Distinguishing debt from equity

Dine, Inc. ABCABC Cash $80,000 Building:FMV$80,000 Basis20,000 Cash$40,000 Goodwill:FMV40,000 Basis0 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 BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $2,040,000 Lind et al., pp

Adjusted BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $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 AspectsNegative Aspects Lind et al., pp

Adjusted BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $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) Lind et al., pp

Adjusted BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $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). Positive AspectsNegative Aspects Lind et al., pp

Adjusted BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $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. Positive AspectsNegative Aspects Lind et al., pp

Adjusted BasisFMV Cash$1,920,000$1,920,000 Building20,00080,000 Goodwill 0 40,000 $1,940,000$2,040,000 Bank loan$ 900,000 Shareholder loans900,000 Common stock 240,000 $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. Positive AspectsNegative Aspects Lind et al., pp