Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F106.SBE

Text File | 1996-01-01 | 8KB | 163 lines

@117 CHAP 8

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            │    THINLY CAPITALIZED CORPORATIONS    │
            └───────────────────────────────────────┘


TAX ASPECTS.  Tax advisers often counsel their corporate
clients to set up their corporations with as much debt cap-
ital 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 deductible to the corporation for
        income tax purposes, unlike the dividends paid
        on its stock.

     .  If properly set up, repayments of the princi-
        pal 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 tak-
en too far.  However, C corporations that have virtually
all of their capital in the form of debt, rather than equi-
ty (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
stock holdings.  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 corporation 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 corporation, but the principal repayments are tax-
able, 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 corpora-
tion that is too thinly capitalized and one that is not,
most courts and tax advisers 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 problem.  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.)

However, there is a horrible TAX TRAP that is somewhat re-
lated, for S corporations, as was illustrated by a recent
tax case.  In the case in question, a business owner set up
an S corporation with only $1,000 of stock, while the corpor-
ation borrowed huge sums of money to do business, with the
owner guaranteeing the loans outside lenders made to the
corporation.  When the corporation ran up huge losses, far
in excess of the owner's $1,000 tax basis in his shares,
all he could write off was the $1,000.  In addition, in such
a situation, if the company goes broke, there is no $100,000
ordinary loss deduction for the stock under Section 1244.
Instead, the owner has to pay off the bad debts, and then
write off such amounts as capital losses, at $3,000 a year
for a few hundred years or so, or until he or she can gener-
ate some capital gains to offset against the capital loss
carryovers.  Not a pretty picture.

For sole proprietorships and partnerships, thin capitaliza-
tion is not a tax issue.  They may have as much debt and as
little equity capital as they wish, and don't have to just-
ify their capital structure to the the IRS (only to their
bankers).

@IF119xx]Thus, because your company is not currently a C corporation,
@IF119xx]the tax problems of thin corporations are unlikely to apply
@IF119xx]to you, except in the event of a change of legal entity to C
@IF119xx]corporation status by @NAME.
@IF119xx]
CORPORATE LAW PROBLEMS OF THIN CAPITALIZATION.  The main
reason most businesses incorporate is to limit the personal
liability of the owners for the debts, taxes and other lia-
bilities of the business to the amount they have invested
in it.  Generally, stockholders in a corporation are not
personally liable for claims against the corporation, and
are, therefore, at risk only to the extent of their invest-
ment in the corporation.  Likewise, the officers and direc-
tors of a corporation are not normally liable for the cor-
poration's debts either, although in some cases an officer
whose duty it is to withhold federal income tax from em-
ployees' 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 shoe-
string."  If a corporation is capitalized too thinly with
equity capital (owner's money) as compared with debt capi-
tal (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, fail-
ure to observe corporate formalities (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.

@IF127xx]Typically, corporations tend to get into this type of trouble
@IF127xx]most often when the stock is owned by a single person, such
@IF127xx]as in the case of @NAME.
@IF127xx]
What this term means is that if a corporation is not ade-
quately capitalized and properly 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 frequent problem is that many banks and other lenders
will not loan money to a small incorporated business unless
someone, usually the stockholders of the corporation, per-
sonally guarantees repayment of the loan.  Despite this
common business practice, the feature of limited liability
can still be an important protection from personal liabili-
ty 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 busines-
ses.  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 poli-
cies if, for example, someone slips on a banana peel in
your store and sues the corporation for $10 million.  While
the corporation might be bankrupted 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.)      │
      └────────────────────────────────────────────────────┘