This course provides an introduction to the U.S. federal income taxation of corporations and their shareholders. The course focuses on the relevant provisions of Subchapter C of the Internal Revenue Code, as well as related Treasury Regulations and judicial opinions, governing corporate formation, operations, distributions, and liquidation. Practical in-class study problems facilitate self-discovery of technical tax knowledge along with the development of a variety of professional skills and attitudes.
Lesson 4.4.1 Debt versus Equity: Concepts
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來自 University of Illinois at Urbana-Champaign 的課程
Taxation of Business Entities I: Corporations
13 個評分
從本節課中
Module 4: Corporate Formation II
In this module, you will continue to explore property-for-stock transactions. Assumption of liabilities and transfer of services along with property will be introduced. Next, you will examine the effects of capital contributions on corporations, shareholders, and non-shareholders. You will also analyze the rules for debt and equity regarding capital structure. Finally, investor losses due to worthlessness of debt/equity investments and bad debts will be discussed.
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Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
Department of Accountancy, Gies College of Business
[MUSIC]
Corporations and their investors structure capital investments as either debt or
equity in order to accommodate different preferences.
For instance, some investors may prefer lower levels of risks and therefore,
seek higher priority levels in the event of corporate bankruptcy.
Likewise, some corporations may prefer to issue interest
providing investors with lower levels of control over business operations and or
different degrees of participation and corporate profits.
In this lesson, you will examine the Federal income tax rules for debt and
equity and consider some of the statutory limitations on the related tax benefits.
After learning these concepts, you will apply them to Sunchaser Shakery.
Note that the concepts in this lesson relate to those of future lessons on
investor losses,
where tax rules often depend on whether an investor holds debt or equity.
Taxpayers have considerable flexibility to design contracts and
financial instruments that can be treated as either debt or equity for tax purposes.
But which also blend features commonly associated with both.
Where does this flexibility come from?
It stems from the fact that there is no clear definition in the code or
regulations that can be used to determine whether an interest in a corporation
constitutes debt or equity for tax purposes.
Furthermore, the IRS ordinarily does not provide individuals with guidance on
whether an interest in a corporation is debt or
equity, because in its view, the issue is factual in nature.
Consequently, differences in the tax treatment of debt and equity
ultimately create incentives to use one or the other depending on the tax traits and
preferences of the issuing corporation, and of the particular investor.
So let's examine the tax treatment of debt and equity for both issuers and
investors and then consider some of the factual distinctions between the two.
For debt instruments,
the issuing corporation recognizes no income upon the receipt of capital and
the investor recognizes no deduction for the investment made.
Thus, as the debt is repaid,
the corporation does not deduct the principal repayment and
the investor does not recognize income on the return of their capital investment.
However, the interest paid to the investor for
use of their investment is deductible from corporate taxable income.
While the interest received is generally taxed as ordinary income by the investor.
For equity instruments, the tax treatment of the initial investment and
return of capital are the same as debt instruments.
That is, the corporation recognizes no income upon the receipt of capital, and
the investor recognizes no deduction for the investment.
If the capital investment is returned to the investor,
the corporation receives no deduction and the investor does not recognize income.
However, when returns on equity are paid to investors,
the tax treatment differs from that of debt.
Specifically, unlike deductible interest expenditures on corporate debt,
dividends paid to the investor by the issuing corporation
are not deductible from corporate taxable income.
The dividends are also taxable to individuals, often
receiving capital character treatment, as well as corporate shareholders.
But the latter could potentially obtain the dividends received deduction you
learned about in a previous lesson.
Note that I have only summarized some of the general rules.
There are many other conditions and exceptions that routinely apply.
The US Congress Joint Committee on Taxation asserts that
the characterization of an instrument as debt or equity for federal tax purposes is
generally determined by the substance of the investor's investment.
Which depends on the terms of the instrument and all the surrounding facts
and circumstances analyzed in terms of economic and practical realities.
It also notes that neither the form of the investment, such as a stock or
debt instrument, nor the taxpayer's characterization of the investment is
necessarily determinative of the investment's correct tax treatment.
Why doesn't the IRS simply accept a taxpayer's characterization of
an instrument as debt or equity?
The short answer,
which is subject to caveats, is that corporations have an incentive to
characterize an instrument as debt over equity, because interest payments on debt
are tax deductible whereas dividend payments on equity are not.
If given free rein to characterize all instruments,
corporations could easily become what the IRS refers to as thinly capitalized.
Thin capitalization is a subjective concept that is said
to occur when shareholder debt is high, relative to shareholder equity.
If a corporation is deemed thinly capitalized, the IRS claims that debt is
really equity, and denies any interest expense deductions.
In such cases, both principal and interest payments are considered taxable dividends.
However, based on current tax rates for
certain types of qualified dividends, recharacterizing debt as
equity might provide benefits to some individual investors.
Ultimately, the right answer depends on the unique facts and
circumstances of both the corporation and its investors.
Along these lines,
code section 385 provides several factors that may, emphasis on may,
be used to determine whether a bona fide debtor-creditor relationship exists.
The section also allows the treasury to issue regulations that
provide definitive guidance.
For many years, however, no regulations were available.
Consequently, both taxpayers and
the IRS relied on common law to make debt versus equity characterizations.
As you might expect,
different courts highlighted different factors to distinguish debt from equity
with no one factor controlling or more important than others.
For example,
one judicial decision lists 30 important factors while another decision groups
the factors into categories with no clear distinction among them.
However, in 2016, the treasury issued regulations under section 385 to
provide guidance in determining whether a debtor-creditor or
a corporation-shareholder relationship exist.
In short, Congress and the courts identified the following
factors to be considered in resolving the thin capitalization issue.
Debt instrument documentation.
Debt terms, such as reasonable rates of interest and maturity dates.
Timeliness of debt repayment.
Whether payments are contingent on earnings.
Subordination of debt to other liabilities.
Whether debt and stock holdings are proportionate.
Use of funds by the corporation.
And the debt-to-equity ratio.
While the ultimate characterization of an instrument as debt or equity
is still subjective, there is at least guidance on which traits to consider.
It is interesting to note that section 385 also permits the IRS to classify
an instrument as either debt or equity, or as part debt and part equity.
This flexibility should come in handy for
the IRS as it attempts to keep up with financial innovation and
the increasing use of complex financial instruments by taxpayers.
