Chap. 3 - Capital Structure of the Corporation

Options - Structuring Corporation’s Capital:

1)   Common Stock, including:

             a)  voting stock;

             b)  non-voting stock; and,

             c)  stock rights and stock warrants.

2) Preferred Stock  - (a) nonqualified preferred stock; (b) qualified preferred stock; (c) convertible preferred stock.

continued

Capital Structure Options, continued

3) Debt:

       a)  Convertible into stock (ordinarily common stock); or,

       b)  Nonconvertible:

          bonds, including  “junk bonds;”        debentures;

          notes;

          trade payables.

Reasons for Corporation to Use Debt (Rather than Equity)

1)  Interest on debt is deductible;  dividends paid are not deductible to the corporation.

2) Repayment of the debt constitutes tax basis recovery to the lender and not a dividend distribution; redemption of the stock may be an ordinary dividend event, not a capital gains event (but both 15% tax).

3) Bad debt deduction (nonbusiness bad debt treatment?) and not a capital loss.

Beneficial Effects of Corporate Debt Leveraging

Enhance the corporation’s return on equity (ROE) component and, thereby, increase the corporation’s earnings per share (EPS).

If shares are normally selling at some multiple of earnings per share, what should happen when the earnings per share are increased by significant debt leveraging?

What is a permissible debt to equity ratio?

Caution:  Leverage is a “two edged sword”.

Impact of the 2003 Legislation re Dividends Tax Rate

1)         Dividends (and capital gains) are taxed at a maximum 15% to individuals.

             Expiration of 15% rate at end of 2012.

2)  Cf., interest income (to the lender) taxed at up to 35 percent (i.e., a 20 percent tax rate differential from the 15% rate for dividends).

3)  But, interest expense is deductible at the corporation level;  dividend distributions are not deductible to the corporation.

Alternative Shareholder Beneficial Tax Planning

Hold the shares for capital appreciation and eventual recognition of deferred capital gains (or §1014 tax basis step-up at death for shares held).

Corporation can use stock buy-backs (market repurchase programs) to compress the shareholder equity base and increase the per share earnings (and, thereby -hopefully- contribute to increased stock appreciation).

Debt vs. Equity Characterization         p.139

Significant factors in differentiating between debt and equity (a fact question) include:

1) The form of the obligation – what existence of  the indicia of a debt, e.g., promissory note?

2) Debt/equity ratio - "thin capitalization”?

    & what is “debt” for determining this ratio?

3) Intent to create a debt (is interest actually paid?).

4) Proportionality - really a “super factor”?

5) Subordination - inside debt/hard to avoid?

Certain Debt vs. Equity Issues                         p.140

Is an IRS private letter ruling available to assure the classification of debt as such for federal income tax purposes?  No.  Rev. Proc. 2011-3, §4.02(1)  - this is a fact issue (p. 140, fn. 4).

What treatment of shareholder guaranteed debt:  recharacterized as an equity contribution? Plantation Patterns case (p. 141) says yes.

Fin Hay Realty            p.142
Were notes really equity?

Demand debt outstanding for a long period.

Issue re deduction of interest expense - §163.

Tax refund action - held to be equity & not debt.

Important factors:    (see the 16 factors)

   Proportionality as the critical element.

   Debt was committed for equity investment by the corporation in real estate ownership and prompt liquidation of the corporate assets was difficult.

What Varieties of Debt (?)
p. 148  

Monthly income preferred securities (MIPs).

Contingent convertible debt securities:

       limited cash interest;  OID; and,       conversion into equity.

Rev. Rul. 2002-31 – contingent convertible debt.

Rev. Rul. 2003-97, Merrill Lynch’s  “feline prides” – 5 year note and 3 year forward contract to purchase issuer’s stock;  the interest expense is deductible. Similar ACES Units, PEPS Units, and Upper DECS.

Code §163(l) – Interest Expense Deduction – p.149

Situation:  The debt is payable in the equity of the issuer (or a related party). 

No deduction is allowed for interest paid or accrued on this “disqualified debt instrument.”

Corporate planning objective:  debt for tax and equity for financial reporting – why?

Code §385                   p.150

Authorizes the promulgation of regulations.

Issues re:   proportionality; and,

                     inside/outside debt ratios

Regulations withdrawn (1969 to 1980 to abandonment) but a continuing impact? Possible bifurcation of putative debt instruments? See §385(a) (parenthetical).  

Example:  “equity kickers.”

Code §385(b) Factors
p.150

1) Form – written instrument?

2) Subordination to other corporate debt

3) Debt/equity ratio

4) Convertibility of debt into stock

5) Proportionality in the holdings of the several shareholders

Possible bifurcation of the instrument – p.152

Problem  Facts              p.153
& Balance Sheet

Assets Adj. Basis F.M.V. Liabilities & Cap. Cash       $1,920,000 $1,920,000    a) Liabilities: Bldg.     20,000       80,000     x) Bank --Goodwill                   0  40,000     $900,000                                                                    y) Sh. Loans                                                         $900,000

                                                        b) Cap. Stock                                                                         $240,000

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

Problem 1                        p.153
Debt-Equity Ratios

(a) Transaction:  Three shareholder loans for $300,000 each;  for five years; variable interest rate one point below prime, determined annually.

What is the “debt-equity ratio”?

          1.8 mil (all debt) to 240,000? (7.5 to 1)   or,

          1.8 mil (all debt) to 140,000? (12.8 to 1)

Or,  is the ratio computed as follows:  900,000 (inside debt only) to either:  (i) 240,000 or (ii) 140,000 (i.e., ratios of 3.75 and 6.42)?

Problem 1                        p.153
Interest Paid from Profits

(b) Transaction: 

Three shareholders - each makes a loan for $300,000; 

each receives a 10% 20 year subordinated income debenture; 

interest expense is payable only from the net profits of the business.

Probably treatment as stock.

Problem 1                        p.154
Guaranteed Loans

(c) Transaction: 

$900,000 (additional) loan from the bank; unsecured but personally guaranteed by the shareholders;

joint and several liability to the three shareholders for this additional loan.

Are also the bank loans equity because of the shareholder guarantee?  Plantation Patterns

Problem 1                        p.154
One Shareholder Lender

(d) Transaction: 

A (only) loans the $900,000 (additional) loan. Terms: 

   five year term; 

   variable interest rate one point below prime, determined annually.

Note:  no proportionality, but high debt-equity ratio.  Really “preferred stock”?

Problem 1                        p.154
Default Two Years Later

(e) Transaction: 

A (only) loans the $900,000 (additional) loan. Same terms (as (d)):  five years & variable interest rate one point below prime, to be determined annually.

Borrower fails to pay interest on the debt.

Issue:  What impact on A’s “original intent” to create a debtor/creditor relationship?

Problem 2                        p.154
Avoiding equity status

Avoiding attributes of hybrid stock:

          reasonable interest rate

          fixed or floating (reference to external rate)

          interest paid with regularity

          fixed maturity date

          no convertibility feature

Quite difficult to avoid equity status if: 

(i) proportionality and (ii) subordination.

Character of Gain or Loss on Corporate Investment

Equity and debt securities held by investors as capital assets (i.e., not traders).

Capital gain treatment for gains on sales.

Special 50 percent exclusion (§1202) for gain on Qualified Small Business Stock (but only 50% of 28% rate; (100% exclusion for 2011;  & later?).

Code §1045 gain rollover provision – postponement when investment in qualified small business stock.

Tax Character of a Loss on Corporate Debt Investment

§§165(g)(1) & (2) (worthless securities)

    capital loss treatment upon sale or becoming worthless.

§166 (bad debts – not a security) –

   - business bad debt as an ordinary loss.

   - nonbusiness bad debt as a short-term cap. loss.

Loan to corporation as an employee – see Generes (next slide)

Generes case       note,  p.155

Issue re business or non-business bad debt status (i.e., what value of the deduction).

Generes owned 44 percent of the stock and was part-time president - salary $12,000.

He advanced funds to the corporation and also guaranteed corporate debts.

Dominant motivation was as an investment, not to protect his employment status (i.e., his “business”).

Section 1244 Stock – Ordinary Loss Deduction                p.155

1. Individuals (and partnerships) only.

2. Common or preferred stock issued for money or property, but not for services.

3.  Small business.

4. Gross receipts test:  requires active business income and not passive income.

5. Annual limit on the ordinary loss amount.

No formal Section 1244 plan is required.

Problem                           p.157
Alternative Investments

Hi-Tech capital structure for venture capital investment.

a)  Five year note - No participation in equity growth; §166 governs if the note defaults.

Nonbusiness bad debt status unless the lender’s business is loaning money.

b) Registered bond - market interest rate.

    Security categorization under §165(g)(2) & STCL status.

Problem,            p.157 cont.

c)  Registered bond;  Bond loss would be worthless security. Code §165(g)(1).  Capital loss.

Concept of "security" includes subscription right.  Loss on warrants - $10,000 – is governed by Code §165(g)(2)(B) &, therefore, a $10,000 LTCL.

d) Common stock - qualifies as §1244 stock. Ordinary loss treatment available? Yes, for 50K (or 100K, if married).

Problem,           p.157, cont.

e) Convertible preferred stock.

Does qualify under §1244.   Eligibility of up to $50,000 loss (or $100,000 on a joint return) if other requirements are satisfied.

f) Original contributions of $500,000 & $500,000. Not a "small business corporation" at the time it issues the additional common stock because aggregate amount of money received for original stock exceeds $1 mil.  Not an ordinary loss, but capital loss.

Problem,           p.157, cont.

g)  Wedding gift.  Donees do not qualify for §1244 treatment.  Son is limited to $200,000 capital loss under Code §165(g)(1).   Reg. §1.1244(a)-1(b).  Only original issuee is eligible for ordinary loss treatment.

h)         Purchase of stock through a partnership.  Partnership is eligible for an ordinary loss deduction under Code §1244. 

      Loss will flow through to the eligible partners (not corporations).