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CORPORATE TAXATION ICORPORATE TAXATION I

TodayToday• 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

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Debt v. EquityDebt v. Equity Why is there still a preference for Debt over Why is there still a preference for Debt over

Equity?Equity?• Repayment of principal is tax freeRepayment of principal is tax free• Interest on the principal is tax deductible to the Interest on the principal is tax deductible to the

corporationcorporation

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Fin Hay Realty Co. v. United StatesFin Hay Realty Co. v. United States Facts: Facts:

• Two shareholders incorporated a business making a capital Two shareholders incorporated a business making a capital contribution of $10K each and loaned the corporation $15K contribution of $10K each and loaned the corporation $15K each. The note was a demand note bearing interest of 6% each. The note was a demand note bearing interest of 6% per annum (used to purchase an apartment buildings for per annum (used to purchase an apartment buildings for $35K in cash)$35K in cash)

• One month later, each advanced an additional $35K on the One month later, each advanced an additional $35K on the same terms as the original note (used to purchase two same terms as the original note (used to purchase two apartment buildings for $75K in cash and a $100K of 5-apartment buildings for $75K in cash and a $100K of 5-year mortgage at 6% per year)year mortgage at 6% per year)

• Three years later, they refinanced the buildings at 4.5% Three years later, they refinanced the buildings at 4.5% per annumper annum

• Over the following 3-years, they each advanced an Over the following 3-years, they each advanced an additional $3K eachadditional $3K each

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Fin Hay Realty Co. v. United StatesFin Hay Realty Co. v. United States Issue: Were the “advances” to the corporation really just disguised capital Issue: Were the “advances” to the corporation really just disguised capital

contributions?contributions? Ruling: Yes.Ruling: Yes. The court noted sixteen factors used by courts and commentators to The court noted sixteen factors used by courts and commentators to

determine the “economic reality” of the transaction (inherently a factual determine the “economic reality” of the transaction (inherently a factual determination):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 (3) the extent of participation in management by the holder of the

instrumentinstrument• (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 (8) the relative position of the obligees as to other creditors regarding the

payment of interest and principalpayment of interest and principal

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Fin Hay Realty Co. v. United StatesFin 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 (16) the timing of the advance with reference to the organization of the

corporationcorporation

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Problems on Page 146Problems on Page 146 Problem 1Problem 1

• A, B & C each contribute $80K in assets in exchange for 1/3 of the stock in Chez A, B & C each contribute $80K in assets in exchange for 1/3 of the stock in Chez Guevara, Inc.Guevara, Inc.

• Chez Guevara requires at least $1.8MM in additional capital, of which it has 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:negotiated a loan for ½ (i.e. $900K) from the bank on the following terms:

Interest = 2pts above primeInterest = 2pts above prime Term = 10-yearsTerm = 10-years Security = the renovated buildingSecurity = the renovated building

Proposal 1(a)Proposal 1(a)• Each loans $300K at 1pt Each loans $300K at 1pt belowbelow prime and a prime and a variablevariable interest rate 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 Each loans $300K of 10%, 20-year income debenture (interest payable out of the

income of the business only)income of the business only) Same factors, but far more problematicSame factors, but far more problematic

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Problems on Page 146Problems 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 Same as 1(a) (i.e. each loans $300K at 1pt belowbelow prime and a prime and a variablevariable interest interest

rate). In addition, each shall personally guarantee the loan from the bank 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 (which is now unsecured) and shall be jointly and severally liable for its repaymentrepayment

• Same analysis as 1(a), except that now the bank loan becomes “suspect”. 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 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 debt ratio (i.e. the debt to equity ratio), making a ruling that both the bank and the shareholder debt is really equity.and the shareholder debt is really equity.

• Proposal 1(d)Proposal 1(d) A will loan the additional $900K at 1pt A will loan the additional $900K at 1pt belowbelow prime and a prime and a variablevariable interest rate interest rate

in exchange for a corporate notein 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 Same as previous, except that two years after getting the note, Chez Guevara

ceases to pay interest on the notes because of cash flow problemsceases to pay interest on the notes because of cash flow problems• Failure to pay interest when due, raises the possibility of reclassification Failure to pay interest when due, raises the possibility of reclassification

after the factafter the fact

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Problems on Page 146Problems on Page 146 Problem 2Problem 2

• DiscussionDiscussion

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United States v. GeneresUnited States v. Generes Facts: Taxpayer made a loan to a corporation owned by his son and Facts: Taxpayer made a loan to a corporation owned by his son and

himself. The Taxpayer, who was president of the corporation, was himself. The Taxpayer, who was president of the corporation, was only a part-time employee, but also held down other positions and 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 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.and received less than 50% of his total income from the corporation.

Issue: Were the loans to the corporation sufficiently related to the Issue: Were the loans to the corporation sufficiently related to the Taxpayer’s employment at the company to make them business Taxpayer’s employment at the company to make them business loans or were they more related to his interest as a shareholder loans or were they more related to his interest as a shareholder which results in non-business debt (and eliminates the Taxpayer’s which results in non-business debt (and eliminates the Taxpayer’s ability to take them as business bad debt when they went unpaid.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 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 taxpayer’s trade or business (i.e. to be a “business” debt for purposes of purposes of §166)§166), the Taxpayer’s trade or business motivation for , the Taxpayer’s trade or business motivation for the debt must be dominant.the debt must be dominant.

Aftermath of US v. Generes is that any shareholder debt is treated as Aftermath of US v. Generes is that any shareholder debt is treated as non-business debt, regardless of the taxpayer’s position within the non-business debt, regardless of the taxpayer’s position within the company.company.

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Problems on Page 157Problems on Page 157 Problem 1Problem 1

• Proposal 1(a)Proposal 1(a) Fails to accomplish her investment goals because she does not Fails to accomplish her investment goals because she does not

participate in the success of the company (i.e. no equity piece) and 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 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 bankruptcy, since we do not know if Jennifer is engaged in the “business” of lending money.“business” of lending money.

• Proposal 1(b)Proposal 1(b) A registered bond is a “security” instrument under §165 and would 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 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 would not allow any participation in the company if successful (i.e. no equity interest)equity interest)

• Proposal 1(c)Proposal 1(c) Same result at 1(b) with the additional ability for her to participate in Same result at 1(b) with the additional ability for her to participate in

the success of the company.the success of the company.

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Problems on Page 157Problems on Page 157 Problem 1Problem 1

• Proposal 1(d)Proposal 1(d) If the stock qualifies for treatment as §1244 stock, then she can treat up to 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 $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 residual would be treated as a capital loss (long-term, if she holds it more than one-year)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 Since the corporation does not meet the “small business” requirements of

§1244 (i.e. has more than $1MM of capital contribution in exchange for §1244 (i.e. has more than $1MM of capital contribution in exchange for stock), any loss would be capital in naturestock), 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. Treatment of loss on §1244 stock is only available to the original recipient.

The subsequent transfer would eliminate any benefits that she might The subsequent transfer would eliminate any benefits that she might otherwise receiveotherwise receive

• Proposal 1(h)Proposal 1(h) Provided that the partnership retains the stock and the loss flows through Provided that the partnership retains the stock and the loss flows through

to the individual partners, each can take the $50K ordinarily income loss. to the individual partners, each can take the $50K ordinarily income loss. If the partnership distributes the shares to the partners, then the §1244 If the partnership distributes the shares to the partners, then the §1244 treatment would be lost.treatment would be lost.