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@117 CHAP 8
┌───────────────────────────────────────┐
│ THINLY CAPITALIZED CORPORATIONS │
└───────────────────────────────────────┘
TAX ASPECTS. Tax advisers often counsel their corporate clients to set
up their corporations with as much debt capital as possible, rather
than having all of their ownership in the form of stock. This can have
two significant tax advantages:
. The interest paid on the debt holders will usually be deduc-
tible to the corporation for income tax purposes, unlike the
dividends paid on its stock.
. If properly set up, repayments of the principal amount of
debt instruments will be a tax-free withdrawal of funds from
the corporation, whereas payment of dividends or redemption
of its stock by the corporation would usually result in taxable
income (capital gain or ordinary) to the shareholder receiving
the payment.
This is usually good tax advice, if the strategy is not taken too far.
However, C corporations that have virtually all of their capital in the
form of debt, rather than equity (stock), may be challenged when they
try to deduct the interest on the debt, particularly if the debt is
held by stockholders, more or less in the same proportion as their
stockholdings. The IRS will argue that such debt is more like "equity"
capital, and, therefore, that the interest paid on it, and often the
principal payments as well, are actually dividends. (Such a corpora-
tion is often called a "thin" corporation, or is said to be "thinly
capitalized.") This can be a "double whammy" if the IRS can make
its case stick.
Not only is the interest expense disallowed as a deduction to the cor-
poration, but the principal repayments are taxable, wholly or in part,
to the shareholder-lenders. Since it is highly tempting, for tax
reasons, to structure a new corporation with as much debt as possible,
a company can easily get into the "thin corporation" predicament when
taxpayers get greedy.
While there is no absolute dividing line between a corporation that is
too thinly capitalized and one that is not, most courts and tax advis-
ers would tend to agree that where debt is more than 3 times equity, a
corporation is probably walking on thin ice for tax purposes in this
regard.
S corporations and unincorporated enterprises do not share this prob-
lem. The IRS tried for years to treat such "thin" debt as a second
class of stock in order to disqualify S corporations (which can only
have one class of stock), but Congress pulled the IRS's plug on this
issue, at least in the case of certain "straight debt" (debt that
has a fixed interest rate and is not convertible into stock,
generally.)
For sole proprietorships and partnerships, thin capitalization is not
a tax issue. They may have as much debt and as little equity capital
as they wish, and don't have to justify their capital structure to the
the IRS (only to their bankers).
CORPORATE LAW PROBLEMS OF THIN CAPITALIZATION. The main reason most
businesses incorporate is to limit the personal liability of the own-
ers for the debts, taxes and other liabilities of the business to the
amount they have invested in it. Generally, stockholders in a corpor-
ation are not personally liable for claims against the corporation, and
are, therefore, at risk only to the extent of their investment in the
corporation. Likewise, the officers and directors of a corporation are
not normally liable for the corporation's debts either, although in
some cases an officer whose duty it is to withhold federal income tax
from employees' wages may be liable to the IRS if the taxes are not
withheld and paid over to the IRS as required.
However, the advantage of limited liability is not always completely
available through incorporation. For example, one must beware of
starting a corporation "on a shoestring." If a corporation is capital-
ized too thinly with equity capital (owner's money) as compared with
debt capital (borrowed money), the courts may determine that it is a
"thin corporation" for corporate law purposes and hold the shareholders
directly liable to creditors. Also, failure to observe corporate for-
malities (commingling corporate and personal funds, not holding board
meetings to approve corporate actions, not maintaining minute books,
etc.) can have a similar drastic result. When this happens, it is
called "piercing the corporate veil" by the courts. What this term
means is that if a corporation is not adequately capitalized and prop-
erly operated to protect the interests of creditors, the courts will
take away the "veil" of limited liability that normally protects the
corporation's shareholders.
Piercing the corporate veil is relatively uncommon. A much more fre-
quent problem is that many banks and other lenders will not loan money
to a small incorporated business unless someone, usually the stock-
holders of the corporation, personally guarantees repayment of the
loan. Despite this common business practice, the feature of limited
liability can still be an important protection from personal liability
for other debts, such as accounts payable to suppliers and others who
sell goods or services to the corporation on credit, typically without
requiring any personal guarantee of payment by the owners. Even this
partial protection is a significant advantage of incorporating most
small businesses. In addition, being incorporated can also protect
you in many cases from personal liability from lawsuit damages not
covered by your corporation's liability insurance policies if, for
example, someone slips on a banana peel in your store and sues the
corporation for $10 million. While the corporation might be bankrup-
ted in such a case, your personal assets would not ordinarily be taken
away by the corporation's creditors, if the corporate veil is not
pierced.
┌────────────────────────────────────────────────────┐
│BOTTOM LINE ADVICE: If you do business in corporate│
│form, (1) Be sure the corporation is not too thinly│
│capitalized; (2) Be careful to observe all necess-│
│ary corporate formalities such as annual meetings of│
│shareholders, board of directors meetings, keeping│
│adequate minute books and other corporate records.│
│(Take particular care not to intermingle your assets│
│with corporate assets, such as bank accounts.) │
└────────────────────────────────────────────────────┘