Accounting 6073
Fall 2011

Lesson 4:  Corporate Capital Structure:  Debt vs. Equity

I.	A Few Comments Re:  Integration

	Note:  This issue is not as hot as it was a few years ago.  Pass through entity rules have been liberalized, and earnings can be taken out of the corporation in other ways besides dividends.  Also, dividends are now taxed at CG rates.

	A.  Treasury asserts the corporate system of double taxation hurts businesses
		1.  Hurts capital formation
		2.  Contributes significantly to complexity of tax laws
		3.  Penalizes the corporate form of doing business
		4.  Encourages use of debt rather than equity
		5.  Encourages retention rather than dist of earnings
		6.  Encourages distributions in form other than dividends
		7.  Competitive disadvantage with foreign (mostly integrated) systems

	B.  Proposals for integration (i.e. elimination of double taxation)
		1.  Eliminate corporate income tax and tax income to shareholders
	2.  Dividends paid deduction for corporations (like interest deduction for debt)
		3.  Exclusion of dividend income for shareholders
		4.  Shareholder credit for corporate income tax paid
		5.  Comprehensive business income tax (CBIT)
			a. top individual rate
			b. regardless of entity form
			c. coupled with exclusion for interest and dividends rec'd

	C.  Treasury prefers dividend exclusion (simple) or CBIT model (revenue neutral), ALI prefers shareholder credit model.

	D.  Treasury doesn't indicate how any lost revenue should be made up.

	E.  Some integration already exists in current law
		1.  It was feared in late 80s that our two-tiered system might
			lead to "dis-incorporation of America."

			a. MLPs were coming into vogue--publicly traded limited				partnership interests

	b. but in 1987--7704IRC said that publicly traded partnerships are taxed as corporations.

		2.  But single level taxation is available thru other means
			a. elective status (check the box) regs. allow entities to 					choose flow thru taxation  unless publicly traded.
			b. LLC--may elect single level taxation, w/ ltd. mbr. liability.
			c. S corp.--if qualify			
			d. dividend surrogates 
				--compensation
				--interest on shareholder loans
				--rent, royalty, lease payments to shareholders

II. Use of Debt or Equity:  An Overview

	A. In general
		1. Corporate organizers are free to capitalize corp. with equity alone or
			with a combination of equity and debt.

		2.  When debt is used--creates additional risk, especially for large corp.
			a.  unsatisfied creditors can force corp. into bankruptcy
			b.  unsatisfied shareholders can only vote to oust directors					

		3. Closely held corp. may not have to worry about addtl. risk, since
			the shareholders may also be the creditors.  This is a key point, 			that goes to the heart of whether “debt” is really debt.

		4.  Thus, especially in closely held corps, capital structure decisions
			may rest mostly (or solely) on tax consequences.

	B.  Use of debt provides a way for corporations to avoid double taxation.
		1.  Treatment of current distributions:  
			a. interest on debt currently deductible by corp
			b. dividends paid by corp not deductible
			c. this gives debt a big advantage--see e.g. p 4-6.
			d. advantage of debt n/a to corps 
				--with persistent losses (can't use int deduction)
				--w/o e&p (dists to s/hs tax free ret of capital)
				--w/ corporate shareholders (they get DRD)

		2.  Treatment of recovery of investment

			a. from corporate point of view, debt vs. equity may not matter, 			since neither corporation’s redemption of its 						shareholder's stock nor repayment of shareholder debt 				is a taxable event.

			b.  investors may prefer debt capitalization (especially with 				closely held corp):

				--most likely, any gain on early retirement of debt 					would be capital gain, whereas.

	--a gain on redemption of stock may be treated as a 	dividend, unless the substantially 	disproportionate redemption rules are satisfied.

				--creditors of closely held corps. taxed on debt 						holdings in same manner as publicly held corps, 				even if they are also shareholders.

			c.  these factors encourage use of debt along with equity.

		3.  Note:  debt is often required to be registered, and loss of interest 			deduction can result of these rules are violated.

III. Debt vs. Equity:  Why do we have to “classify” it?	

	A.  In General
		1.  Code does not draw fixed boundary line
		2.  Crux of problem:  "debt" and "equity" are labels that mark two 			ends of a continuum:
	
			a. straight debt:  an unqualified obligation to pay a sum certain 				at a reasonably close fixed maturity date along with 				a fixed percentage in interest payable regardless					of the debtors income or lack thereof.

			b. equity:  connotes an unlimited claim to the residual benefits				of ownership and unlimited subjection to the 					burdens thereof.

		3.  In between these two poles are an infinite number of kinds of 			instruments with blended characteristics.

	B.  Disputes in this area tend to occur with frequency in three circumstances:
1. In context of a 351 transaction, does an instrument qualify as “stock, which in turn allows deferral of gain?

		2.  During "term" of the instrument--are payments by corp. interest or
			dividends?
	
		3.  At maturity—because different tax treatment may apply depending 	
			on whether instrument is stock or debt.
	
	C.  Shareholders vs. Third party creditors:  A key classification issue			1.  If creditors are also shareholders, even the straightest of s/h 
			held debt may be reclassified as equity.
			
			-- this is because shareholders unlikely to insist on payment if 
				it would throw the corp. into bankruptcy

		2.  Therefore, any s/h held hybrid also vulnerable to reclassification.
		3.  Straight debt held by 3rd parties: courts usually accept debt 	label. 
		4.  Hybrids held by third parties:  weighing of factors.

	D.  Code section 385(a) authorizes regulations bifurcating investments.

	E.  Treasury doesn't issue advance rulings in this area (it considers this a 
		question of fact) while courts are divided as to whether it is a question 
		of law, or of fact (reviewable only under the clearly erroneous std.)

	F.  Value of Precedent:  while prior cases usually helpful in suggesting
			a result, they are not dispositive, since every situation is somewhat 	unique.

	G.  Bottom line:  results are hard to predict, thus lots of risk in this area of 	practice.

	H.   Treasury authority under section 385
		1.  History (1954-1983)
			a. attempt to write precise definitions into 1954 code 
				rejected--congress recognized that instruments could
				 be given too many interchangeable characteristics.

			b.   but in 1969, congress enacted 385 IRC and gave treasury
				 authority to issue regulations in this area.

			c. in the 80s, treasury finally issued regs., but they proved
				unworkable--withdrawn in 1983.

		2.  More recent developments
			a. consistency rule (1992)—issuer’s characterization of 
				instrument binds issuer and holders.  Holders may
				take inconsistent position if they disclose it on their
				return.

			b.  E.G.:  a holder of an instrument treated as debt 						by issuer may take the position that it is an equity 				instrument and that “interest” payments are dividends 				taxed at 15%.  But he must disclose this position in a 				statement on his return.

			c. 1996 proposal (not passed)--if instrument term longer 				 than 15 years, deemed equity, unless issuer treats
				 as debt for financial reporting purposes.

IV. Classifying Hybrid Securities

	A.  Business reasons for using hybrids
		1.  Maybe attempt to have tax advantages of debt (interest deduction)
			w/o financial impairments of debt (hurts ability to borrow
			from other sources)

	2.  But in an increasingly complex environment, hybrid instruments may be used to reflect what has been bargained for e.g.

			a. creditor may want to share in appreciation of business
			b. equity investors may want to limit their exposure, especially 
				in high risk investment.

	B.  Classification Criteria

		1.  Overview--criteria are difficult to apply
			a. from case law--which almost never identifies one factor
				as necessary or sufficient for classification as D or E.
			b. generated primarily for closely helds where debt held
				in proportion to stock (high scrutiny situation)
			c. criteria are numerous, non hierarchical
			d. few explanations as to why they are significant

		2.  Criteria generally point to one of three classification indicators:
	a. do formal rights and remedies of parties point to debt or equity classification?
			b. genuineness of intent to create debtor/creditor relationship
			c. reasonableness or economic reality of the intention
	
		3. A checklist of relevant factors
			a. intent of parties
			b. identity between creditors and shareholders
			c. extent of participation in management by instrument holders
			d. corp.'s ability to get outside financing
			e. "thinness" of capital structure
			f. risk
			g. the formal aspects of the arrangement
			h. degree of subordination of interest & principal payments
			i. voting power of instrument holder
			j. provision of fixed rate of interest
			k. is obligation to repay contingent?
			l. source of interest payments
			m. fixed maturity date?
			n. provision for redemption by the corp.?
			o. provision for redemption at holder's option?
			p. timing of advance relative to organization of corp.

		4.  Maturity date
	a. virtually essential to debt classification-(lack of one almost certainly indicates equity.)
			b. necessary but not sufficient
			c. must not be too far in future, given nature of business

		5.  Remedies for Default--creditors can sue, shareholders can only
			vote out directors.

		6.  Subordination--more subordinate instruments look more like an 
			equity investment.  But not automatically equity if ranks 
			ahead of pref. and common stock.

		7.  Certainty of return
			a.  if interest payments dependent on corporate earnings, looks
				more like equity
			b.  certainty of return of principal virtually essential for debt

		8.  Participation in corporate gains
			a.  instrument with this feature is not automatically equity
			b.  if exercise of conversion privilege is virtually certain, or
				limited assets for repayment, may disregard	debt label.

		9.  Participation in gains and losses--much more like equity
			since this undermines principle of certainty of return

		10.  Participation in control--marginal factor.  Not unusual for
			bonds to place restrictions on payment of dividends

		11.  Label applied by parties
			a.  even unambiguous labels not controlling however,
			b.  courts reluctant to allow parties to repudiate labels

		12.  Approach is to balance and weigh these factors in some way

		13.  Debt w/ "equity dominant" features--debt payable in equity is
			considered equity for purposes of denial of interest
			deduction, debt for all other purposes.

V.  Classifying Shareholder (and Other Non Arms Length) Debt:  Intention and 
	Economic Reality

	A.  In general
		1.  Efforts to reclassify NON hybrid securities usually occur in 
			corporations where shareholders hold debt in proportion to 			stock.

		2.  Issues:
			a.  are debt terms "arms length"
			b.  is there a debtor creditor relationship (i.e. will
				shareholder/creditors enforce their rights
				if corp. doesn't pay)?
			c.  related parties involved?

		3.  In these cases, form does not carry much weight, because
			parties may mold it to suit their common interests.

	B.  Factors that increase the risk of reclassification to equity

		1.  Pro Rata Holding of Stock and Debt
			a. Not fatal to debt classification, but tends to "poison the				atmosphere"
			b. Courts scrutinize these transactions carefully.

		2.  Excessive Debt to Equity Ratio ("Thin" Capitalization)
			a. In such cases, even straight debt may be reclassified, because
	in light of minimal equity, debt holders are de facto stock-holders as far as risk is concerned.

			b. In computing debt to equity ratio
				i. use fair market value of assets (not book value)
				ii. include goodwill
	iii. outside debt considered debt, especially if guaranteed by shareholders.

			c. Usually assumed that DE ratio of < 3:1 will withstand attack.
	 Less favorable ratio will invite attention, but usually only a factor.	Will not of itself lead to reclassification.

			d.  The acceptable ratio may vary by industry and type of debt.
		
		3.  Debt issued for "Essential" assets
	--Courts have held that debt is not bona fide if issued for "core" assets needed to get business going, absent a good business reason for using debt rather than equity.

		4.  Lack of intent to Create Debtor-Creditor Relationship
	a. Tax court has come close to holding that s/h advances to corp. can never be bona fide.

			b. But more traditional view:  Gilbert V. CIR
				Key Question:  Does s/h-lender have a reasonable 
				expectation of repayment?
		
			c. Thus, look to objective criteria
				i. D/E ratio of business
				ii. pro-rata holding of stock/debt
				iii. the use of the borrowed funds
				iv. would outside investors have lent on similar terms?
				v. conduct consistent with that of a creditor
	--history of tolerating default/extensions may indicate debt is not bona fide.
	--meticulous compliance with lending terms helps, but is not dispositive.

VI.  Application of Debt Equity Rules to S Corporations	
	A.  One Class of Stock Requirement
		1.  As noted previously, S Corporations may have only one class of
			stock--this is to facilitate allocation of income.
		
		2.  One class of stock if all outstanding shares confer identical rights
			as to income, distributions and liquidation proceeds
		
		3.  Variations in voting rights will not violate "one class" rule

	B.  Anxiety:  Will purported debt instruments be treated as 2nd class of stock?
		1. In response--1361(c)(5) provides a safe harbor for straight debt if:
		
			a.  interest rate, payment dates not contingent on profits, 
				borrower's discretion or similar factors
			b.  obligation not convertible directly or indirectly into stock
			c.  creditor is qualified to be an S shareholder
			d.  instruments meeting these rules will not be treated as 2nd
				class of stock, even if equity for other purposes

		2.  BUT:  Purported debt may be a 2nd class of stock if
			a.  constitutes equity under general federal tax principles and
			b.  has a principal purpose of contravening rights to 
				distributions or liquidation proceeds
			c. safe harbors available to avoid this rule for 
				--short term advances
				--proportionately held obligations
				--straight debt
				--certain options

	C.  Basis adjustment for S Corp Stock and Debt
		1.  For stock
			a.  increase for gross income passed thru
			b.  decrease for deductions and losses
			c.  decrease for distributions

		2.  For debt--If stock basis is reduced to zero, per adjustments above
			a.  further downward adjustments applied against basis of 
				s/h loans to corp.
			b.  s/h has no basis in debt s/he guarantees unless required to 
				perform, (but if s/h makes the loan, has basis).
			c.  Debt basis is restored by positive adjustments in later years
			d.  Debt basis restored before stock basis

		3.  If losses exceed basis in stock and debt
			a.  excess may not be deducted currently by shareholder
			b.  may be carried forward indefinitely
			c.  may deduct currently if s/h makes capital contribution or 
				loans additional funds to the corp.

4.	E.G.:  S Corp has one shareholder with basis of 400 in stock and 			200 in s/h loan to corp.  For the year, corp has 150 in 			OI, 200 CL and makes 500 dist at end of year.  
				Basis of shareholder in stock:  400 + 150 -200=350
	
				Basis of shareholder in loan:  200

				Dist of 500 first reduces stock basis to 0, then loan basis to 50.  				Income in future year will restore basis in loan to 200 first 					before it restores any basis in 	stock.