Tara and Jeff wish to form TJ Corporation. They have determined that they need initial capitalization of $1,000,000. What tax issues should they consider when determining whether to issue stock only or some combination of debt and equity?

Question

What will be an ideal response?

Answer 1

One consideration is the tax treatment of the earnings on the two alternatives. If stock is issued and the corporation pays dividends, the dividends are not tax deductible to the corporation but the dividends are taxable to the stockholders, although at a preferential rate. On the other hand, if bonds are issued, the interest is tax deductible, and the interest income is taxable to the bondholder at ordinary rates. A second consideration revolves around the liquidation of the stock or debt. A redemption of stock will be taxable and may result in dividend treatment whereas the repayment of debt is tax-free return of capital. A third consideration may be a non-tax consideration. There is a legal obligation to repay the debt on the maturity date, whereas there is no obligation to redeem stock. Another important tax issue is whether an excessive amount of debt will trigger the Sec. 385 debt-equity rules to recharacterize the debt as equity. If appreciated property is exchanged for the stock, Tara and Jeff must also consider the effect of the issuance of debt upon the requirement for recognition of gain by Tara and Jeff under Sec. 351(b) as a note will be considered boot. In the event of the corporation subsequently failing, worthlessness of debt is treated as short-term capital loss, and the noncorporate shareholder is limited in recognizing the loss due to the $3,000 capital loss limitation. In the case of stock, the shareholder may be able to take advantage of the $50,000 ($100,000 if married) ordinary loss treatment available to qualifying small business corporation stock under IRC Sec. 1244.