C-Corp Capital Structure and Shareholder Debtby
As you may be aware, the shareholder as lender has interest income as a result of including debt in the corporate structure. We will cover some of the interesting updates in this important area of corporate interest expense, but our theme is the traditional benefit that comes when shareholders in closely-held corporations are also lenders.
If a C corporation has accumulated current earnings and profits, distributions classified as dividends are not deductible by the corporation, but are taxable to the shareholder. Mere distribution of earnings and profits results in double taxation. A shareholder who is also a lender may receive tax-free loan repayments without the double-taxation problem generally attendant to receiving dividends.
Including debt within the corporate structure may enable the lender, even though the lender is also a shareholder, to receive debt repayments rather than dividends. The corporation’s interest deduction also reduces its taxable income.
Removal of Certain Requirements
Our topic gets particularly complicated and IRS-taxpayer contentious when the context includes large international companies and results that the IRS may see as shifting assets to low-taxation foreign jurisdictions. See, for example, Section 385 and the recent removal of certain requirements (T.D. 9880, 84 FR 59297-59302, effective November 4. 2019).
These regulations removed certain documentation requirements that needed to be met to treat related-party interests in a corporation as debt for federal tax purposes. There were also new proposals (See also Notice 2019-58). The IRS released final regulations in May, 2020, aka the “2020 Final Regulation” (See T.D. 9897, effective May 14, 2020, 85 FR 28667-28883).
This year’s Treasury Decision under Section 385 is briefly summarized by one of the large CPA firms as follows: “These regulations recharacterize a debt instrument issued by a domestic corporation as stock if the instrument is issued to a member of the domestic corporation's expanded group in a distribution, in exchange for related-party stock, or in exchange for property in certain asset reorganizations”(“Breaking Tax News, IRS finalizes regulations on characterizing certain corporate interests as stock or debt under Section 385,” EY Tax News Update, U.S. Edition, Ernst Young, May 13, 2020, 2020-9030).
There is also the relatively recent, much discussed Section 163(j) as amended in the 2020 CARES Act. After 2017, this provision limits the interest deduction of large taxpayers (On July 28, 2020, the IRS issued final regulations under Section 163(j); T.D. 9905, effective November 13, 2020, 85 FR 56686-56845. See also Basic questions and answers about the limitation on the deduction of business interest expense, irs.gov).
Such provisions as Sections 263A and 266 can affect whether interest deductions get capitalized as assets. The general topic of distinguishing debt from equity for tax purposes, the measure and reasonableness of interest expense, distinguishing when interest is an expense or a capital expenditure, these and related topics can quickly become complicated matters requiring tax research.
However, it is also important to remember the potential importance of including debt in the closely-held, mid-sized corporation’s capital structure because distributions in repayment of debt may effectively avoid dividend treatment, while also generating a corporate interest deduction.
Resolving the Relationship
As a separate entity for tax purposes, the closely-held corporation deducts interest expense on shareholder debt in a manner similar to reasonable compensation for shareholder services. Interest expense is often less complicated than compensation, which has attendant payroll taxes and other considerations. There are interest capitalization issues that may need to be reviewed. However, interest expense will generally be deductible if the debt-equity structure is reasonable (Section 163).
For example, a 99.5 percent debt and 0.5 percent equity structure is likely going to result in the debt being classified as equity for tax purposes. Section 385(b) lists certain factors to be taken into account in resolving whether there is debtor-creditor or a corporation-shareholder relationship. The statutory list of factors for consideration is as follows:
1. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest.
2. Whether there is subordination to or preference over any indebtedness of the corporation,
3. The ratio of debt to equity of the corporation,
4. Whether there is convertibility into the stock of the corporation
5. The relationship between holdings of stock in the corporation and holdings of the interest in question.
It isn’t difficult to find additional factors to consider in resolving debt/equity questions (See the much longer list of factors in Dixie Dairies Corp., 74 T.C. 476 (1980); See also Illinois Tool Works, Inc., T.C. Memo 2018-21).
The basic focus of the tax rules is that interest and note terms need to be reasonable and realistic. Items classified as debt should be treated as such. Notes should bear reasonable interest and be paid according to the note’s terms.
Below-market loans between a shareholder and corporation may be subject to adjustment under the rules of Section 7872 (Section 7872(c’)(1)(C’).
In general, capitalization of the C corporation should be periodically reviewed with a view to the degree, if any, that shareholder-debt should be included in the corporation’s capitalization. We know our topic can get complicated, but the tax savings at issue may also be significant.
The review of dividends needs to keep in mind such distributions are nondeductible to the corporation yet usually taxable to the C corporation’s shareholders. Shareholder debt in the capital structure is a primary route to mitigating this dilemma of getting funds out of the profitable C corporation without having a taxable dividend to the shareholder.
Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...