Software of the Month Club 1997 March/Software of the Month Club 1997 March.iso/pc/dos/lg/sba/f106.sbe

Text File | 1996-08-23 | 8.5 KB | 173 lines

@117 CHAP 8

            ┌───────────────────────────────────────┐
            │    THINLY CAPITALIZED CORPORATIONS    │
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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 at least
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 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
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 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 those
corporations that are too thinly capitalized and those that
are 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
related, for S corporations, as was illustrated by a recent
tax case.  In the case in question, a business owner (who
was a CPA and should have known better) set up an S
corporation with only $1,000 of stock, while the corporation
borrowed huge sums of money to do business, with the owners
guaranteeing the loans outside lenders made to the company.
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 unless or until he or she is able
to generate some capital gains to offset against the capital
loss carryovers.  Not a pretty picture.

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).

@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]
@IF113xx]However, since your business is structured as a limited
@IF113xx]liability company, it is probable that as the law develops
@IF113xx]for LLCs, a similar rule for "thin LLCs" will develop.
@IF113xx]
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
liabilities 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, thus, at risk only to the extent of their investment
in the corporation.  Likewise, the officers and directors
of a corporation aren't 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 held 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 capitalized 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, the
failure to observe corporate formalities (such as by
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
adequately 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.

@IF113xx](Note that, although your business is structured as a limited
@IF113xx]liability company, and not a corporation, it is probable that
@IF113xx]as the law develops for LLCs, a similar rule regarding "thin
@IF113xx]LLCs" will emerge for limited liability companies that are too
@IF113xx]thinly capitalized, "piercing the LLC veil" as well.)
@IF113xx]
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,
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 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 necessary│
      │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.)      │
      └────────────────────────────────────────────────────┘