Law Outlines Corporate Tax (Duke Zelenak) Outlines
Corporate Tax outline for Professor Zelenak from Duke Law...
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Equity: issuing stock in exchange for contributions of money
Double tax: dividends includible in SH’s income and not deductible by the corporation
Redemption of shares (buys back) from a SH, entire amount taxed as a dividend if the SH or related persons continue to own stock in the corporation
Debt: borrowing money: bonds, notes, etc.
No double tax: interest paid on corporate debt is includible in recipient’s income, but is deductible by the corporation
Repayment of debt is tax-free return of capital, gain treated as capital gain
Example: X earns 100, pays out to A
As interest, deductible by the corporation, 0 corporate tax
100 income to A
A gets 60.4 after 39.4% income tax
As dividend, corporations pays 35% corporate tax
100-100*35=65 dividends after tax
20% dividend tax on the 65 -65*20%= 52
Therefore, you prefer debt to equity.
Common law standards
To prevent tax avoidance through the use of excessive debt, IRS may reclassify a purported debt obligation as equity.
Common stock (risky, equity) preferred stock (in the middle, treated as equity) debt (safe)
Preferred stock is preferred to common stock, with respect to liquidation proceeds and dividends
Preferred stock is a stock, you get preference on dividends over common stock, if the corporation decides to pay dividends, up to the preference limit.
The excess to the preference limit goes to common stock
If the corporation liquidates, preferred stock gets payment second (after debt), up to the preference limit
Payment treated as dividend, not deductible
Section 385
Section 385(b) factors
Form
if you want it to be qualified by debt, it needs to have debt characteristics
Debt instrument should have an unconditional promise to pay; a specific term; remedies for a default; stated, reasonable rate of interest, payable in all events
Subordination to any indebtedness of the corporation
If payment to outsider debt first, then SH’s debt looks like equity
The debt/equity ratio
High debt/equity ratio creates a substantial risk that what purports to be debt will be reclassified as equity
Test: under similar circumstances, would a rational creditor would lend money to a corporation with such nominal equity? If no, then treat all the debt as equity
Convertibility to stock
If debt is convertible to stock, it’s more likely to be treated as equity
Proportionality
If debt held by the shareholders is in the same proportion as their stock holdings, debt may be treated as equity.
Proportion calculation, choose the lesser of stock and debt of each SH and add them up.
As proportion gets closer to 100%, the more likely debt may be treated as equity
A | B | C | |
---|---|---|---|
Stock | 40% | 50% | 10% |
Debt | 45% | 45% | 10% |
Proportion = 95% | 40% | 45% | 10% |
385(c)(1): classification made by the issuer is binding on the issuer and all holder of the instrument
Problem 1 on 142-43
SH | Contribution for stock | Shares |
---|---|---|
A | 80 cash | 100 |
B | Bldg 80V 20B | 100 |
C | 40 cash, good will 40V 0B | 100 |
Also 900 bank loan, prime+2, 10 years, secured
300 loan from each SH, 5yr, prime -1,unsecured borderline
Debt/equity ratio, four combinations possible
Proposed regulation: use equity at basis
Courts generally look at equity at value
Inside+outside debt=1.8M
Inside debt alone=0.9M
Equity at book: 0.24M
Equity at...
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Corporate Tax outline for Professor Zelenak from Duke Law...
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