Debt-Equity Trade - Off

1
Debt-Equity Trade - Off

All Equity
Debt/Equity Assets
1,000,000
1,000,000 Debt
0
600,000 Equity Capital
750,000
150,000 Retained
Earnings 250,000
250,000 Total
Equity 1,000,000
400,000 Earnings
distributions Dividend
Interest Capital
distribution Dividend
Loan Repay Return on
equity of 150k operating income
15
28.5 and 36k interest expense
2
Debt-Equity Factors
1. Documentation Unconditional promise to
pay specified term
interest rate default remedies 2.
Debt/Equity Ratio Inside and Outside debt.
Book value v.
Market Value. If ratio over 5-to-1 based on
total debt and book value, must be able to show
consistent profitability and cash flow will
support debt. 3. Proportionality Same ratio
as stock ownership 4. Subordination Inside
debt inferior to outside debt 5.
Convertibility Debt convertible to stock

LLM Corporate Tax Instructor
Dwight Drake
3
Problem 502-1 (a)
Bank
900k loan
Chez Corp.
80k cash for 100 shares
40k cash business (40k) for 100 shares
Bldg 80k for 100 shares Basis 20k
A
C
B
300k five-year note Variable interest
300k five-year note Variable interest
300k five-year note Variable interest
(a) Issue Will 900k shareholder debt be
treated as equity for tax purposes?
Consequences Interest payments not deductible
all interest and principle payments taxed as
dividends to extent of E P. Factors
Form of debt (no problem) proportionality
(problem) Debt- Equity ratio (problem
12.851 (Cost) 7.51 (FMV)) Capacity to repay
(?) intent to repay (?) subordination (?).
Probably cooked here.
4
Problem 502-1
Chez
Balance Sheet Post Funding

Cost FMV
Assets Cash
1,920,000
1,920,000 Building
20,000
80,000 Goodwill
0
40,000 Total
1,940,000
2,040,000 Liabilities
Bank Loan 900,000
900,000
Shareholder Loan 900,000
900,000 Total
1,800,000
1,800,000 Equity
140,000
240,000 Total Liab.
Equity 1,940,000
2,040,000
LLM Corporate Tax Instructor
Dwight Drake
5
Problem 502-1 (b)
Bank
900k loan
Chez Corp.
80k cash for 100 shares
40k cash business (40k) for 100 shares
Bldg 80k for 100 shares Basis 20k
A
C
B
300k 20 year debenture Interest 0nly from
profits
300k 20 year debenture Interest 0nly from
profits
300k 20 year debenture Interest 0nly from
profits
(b) No hope. Too long bad form (Debenture?)
squirrelly interest (like dividend)
subordinated flakey intent to repay.
LLM Corporate Tax Instructor
Dwight Drake
6
Problem 502-1(c)
Bank
900k loan unsecured
Chez Corp.
80k cash for 100 shares
40k cash business (40k) for 100 shares
Personally Guaranteed
Bldg 80k for 100 shares Basis 20k
A
C
B
300k five-year note Variable interest
300k five-year note Variable interest
300k five-year note Variable interest
(c) Bank loan may also be equity if corp thinly
capitalized, unlikely corp can pay back debt, and
bank expects ultimate repayment from
shareholders. Guarantee itself wont kill given
prevalence of shareholder guarantees in private
businesses. Need more facts here.
LLM Corporate Tax Instructor
Dwight Drake
7
Problem 502-1(d)
Bank
900k loan
Chez Corp.
80k cash for 100 shares
40k cash business (40k) for 100 shares
Bldg 80k for 100 shares Basis 20k
A
C
B
900k five-year note Variable interest
(d) Much safer because no proportionality. But
385 Regs. would have subjected non-proportional
loan to proportional scrutiny if made by over 25
shareholder and had debt-to-equity ration over
101 (based on cost).
LLM Corporate Tax Instructor
Dwight Drake
8
Problem 502-1(e)
Bank
900k loan
Chez Corp.
80k cash for 100 shares
40k cash business (40k) for 100 shares
Bldg 80k for 100 shares Basis 20k
Chez default in year 3
A
C
B
900k five-year note Variable interest
(e) Failure to pay can trigger reclassification
as equity if there is no effort made to enforce
rights under default. 385 Regs. required second
look if debt not paid. What to do? Renegotiate
based on market standards and then properly
document.
LLM Corporate Tax Instructor
Dwight Drake
9
Problem 502-2
Given vagueness, how to advise
1. Carefully draft to avoid any hybrid stock
attributes. 2. Market interest rate,
term, maturity and payment terms. 3.
Avoid proportionality and subordination, if
possible (often not). 4. Manifest
intent to repay (terms, remedies, maybe even
security). 5. If possible, keep total
debt/equity ration under 101 and inside
under 31 (the 385 Reg safe harbors).
6. Make sure payments are made.
LLM Corporate Tax Instructor
Dwight Drake
10
Problem 502-3
Hi-Tech Corp.
400k cash for 50 shares
200k cash Secure, growth, tax smart
400k cash for 50 shares
A
J
T
a) 200k unregistered 5 yr note, market rate
interest. No upside potential. Since not
registered and no coupons, not security under
165(g). Hence, loss subject to 166, which
permits ordinary loss if it business bad debt
incurred in Jennifers trade or businesses. If
non-business, then short-term capital loss. Key
factor is that business, not investment, must be
dominate motive. Need info Was J employee of
Hi-Tech, in business of loaning money, or had
need to protect business relationship with
H-Tech? If no, then STCL treatment.
LLM Corporate Tax Instructor
Dwight Drake
11
Problem 503-3 (b),(c),(d)
Hi-Tech Corp.
400k cash for 50 shares
200k cash Secure, growth, tax smart
400k cash for 50 shares
A
J
T
b) 200k registered bond. Still no upside. Since
registered, is security under 165(g). If J
hold a yr. as capital asset, loss will be LTCL.
c) 190k registered bond with warrants to
purchase stock (warrant cost 10k). Both bonds
and warrants securities under 165 LTCL
treatment. d) 200k common stock. Per 1244, 50k
(100K if married) of worthless stock loss may be
ordinary then rest LTCL. For 1244, J must be
original issuee stock issued for cash aggregate
amount corp received for stock not over 1 mill
corp receives over 50 of receipts from
non-passive investment sources.
LLM Corporate Tax Instructor
Dwight Drake
12
Problem 503-3 (e) thru (h)
Hi-Tech Corp.
400k cash for 50 shares
200k cash Secure, growth, tax smart
400k cash for 50 shares
A
J
T
e) 200k convertible preferred stock. May
qualify for 1244 treatment as described in d), a
1984 change in the law. f) Common stock to
Jennifer, original shareholders capitalized for 1
mill. No 1244 treatment available to Jennifer.
Stock loss capital loss pursuant to 165(g) g)
Common stock to Jennifer, who gives stock to son.
Gift would kill 1244. Only original issuees. h)
Purchase common stock through partnership.
Partnership may qualify for 1244, passing through
to each partner.
LLM Corporate Tax Instructor
Dwight Drake