Stock in Merlin Corporation is held equally by Jane, Eve, and Fred. Merlin seeks additional capital to buy a valuable tract of land that will cost $6,000,000. Jane, Eve, and Fred propose to loan Merlin $2,000,000 each, taking from Merlin a $2,000,000 10-year note with interest payable annually at five points above the prime rate. Merlin Corporation has current taxable income of $7,000,000. How are the payments on the notes treated for tax purposes?
What will be an ideal response?
Payments on the notes will probably be treated as dividends for tax purposes. The debt instruments have too many features of stock. The debt does not bear a legitimate rate of interest, and the debt is proportionate to the stock holdings of Jane, Eve, and Fred. Merlin Corporation has substantial current taxable income indicating an attempt to withdraw earnings in the form of principal and interest payments on debt obligations rather than as dividends.
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What will be an ideal response?