Debt vs. Equity?
By Richard M. Colombik, JD, CPA
How is your practice set up?
Is it a C corporation, or a flow through entity, S corporation, Limited Liability, or Partnership? Or are you a sole proprietor?
If a C corporation, the reason this simple question is important, is that payments of dividends are not deductible by a corporation, but the payments of interest are deductible. Therefore, the payment of interest reduces corporate taxable income, and corporate income tax, whereas the payment of a dividend, being non deductible does not decrease corporate taxable income and does not reduce corporate income tax.
The tax code within IRC §163(a) allows a deduction for all interest paid or accrued, but the code does not provide a section for deducting dividends paid. The question relates to whether a payment to the shareholders is a payment on a valid debt, an interest payment or a payment on their equity, a dividend. This distinction is not just for income tax law, but can also arise out of a bankruptcy context, regarding deducting bad debts as well.
Lets look numerically at the difference:
Payment to shareholder $100,000 $100,000
Corporate tax $(39,000) $ 39,000 *
Maximum federal rate
Personal Tax $ 35,000 $ 15,000
Maximum federal rate
Net Total Tax $ (4,000) $ 54,000
* as there is no corporate tax deduction on a dividend the total payment of $100,000 is subject to tax at the presumed maximum corporate rate
Sometimes the distinction is very easy, but in the case of closely held companies the distinction becomes blurred. According to court cases, a loan, is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date, with interest payable, regardless of the debtor?s income or lack thereof. With many closely held corporations, the debt is payable on demand, not a fixed date, and the interest rate may not be fixed, or payments irregular. So what factors does one have to look at?
In a typical court fashioned doctrine, the underlying form, rather than the mere substance of a transaction is analyzed. Is this obligation, in terms of economic reality truly a debtor creditor obligation, or is it something else?
There is no one settled approach to this issue, but the circuit courts, according to Indmar Products Co., Inc. v. Commissioner, 05-1573 (6th Cir. 2006), have set out eleven non-exclusive factors for courts to consider:
- the names given to the instruments, if any, evidencing the indebtedness;
- the presence or absence of a fixed maturity date and schedule of payments;
- the presence or absence of a fixed rate of interest and interest payments;
- the source of repayments;
- the adequacy or inadequacy of capitalization;
- the identity of interest between the creditor and the stockholder;
- the security, if any, for the advances;
- the corporation?s ability to obtain financing from outside lending institutions;
- the extent to which the advances were subordinated to the claims of outside creditors
- the extent to which the advances were used to acquire capital assets; and
- the presence or absence of a sinking fund to provide repayments.
No single factor is controlling, and such each case must be viewed on its facts and circumstances. So what does one do to try and be reasonably safe?
First, have a written loan agreement.
Second follow its terms! You would be amazed how many businesses actually have the documents and then do not bother to even follow their terms.
Third, actually make interest and if required principal payments, on time!
Fourth, charge a reasonable rate of interest, no lower than the government?s applicable federal rate, and normally within a reasonable range from what your bank would charge your business for an unsecured or secondary loan.
If the loan is secured, file your financing statement and follow normal legal procedure. On your financial statements reflect the loan as a true loan. If applicable, have your accounting firm, provide footnote disclosure of the related party nature of the loan and its terms. Report the interest income you receive on your personal return. Have your company issue a form 1099 for the interest as required. Be consistent and treat the transaction as you would with a third party creditor.
The government may not like the loan classification and push for dividend treatment, but it does NOT mean they will win if you follow the logic and steps outlined by the courts. Remember this important quote for the courts:
Tax avoidance is entirely legal and legitimate. Any taxpayer ?may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one?s taxes.?? Estate of Kluener v. Commissioner, 154 F.3d 630, 634 (6th Cir. 1998) (quoting Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (L. Hand, J.)).
So follow the rules and do not forget the importance of having a good tax lawyer document your business transactions to protect you, your company and your family from unnecessary and unintended tax consequences.
Having a deductible loan versus is a dividend is legal, just do it properly and you will be able to obtain the results you seek!