If you decide to use a C corporation to operate your newly acquired business, you should know that our current federal income tax system treats corporate debt more favorably than corporate equity.
So, as the owner of a closely held C corporation, you may find that including some third-party debt (owed to outside lenders) and/or some owner debt (owed to yourself) in your corporation’s capital structure is a tax-smart move. I wanted to give you a glimpse of how this works.
The main advantage of using third-party debt financing for a business acquisition by your C corporation is that you do not have to commit as much of your own money to make the deal.
Even if you could afford to cover the entire cost with your own money, tax considerations may make this inadvisable. That’s because a C corporation shareholder (like you) generally cannot withdraw part of his or her equity investment without worrying about the dreaded double taxation issue.
If the corporation has current or accumulated earnings and profits, all or part of the withdrawal will be treated as a taxable dividend. You want to avoid dividends if you can.
Taxable dividend treatment means taxable income for you without any offsetting deduction for your corporation. That is after your corporation has already been taxed on its profits. This is double taxation in all its glory.
When third-party debt is used in your corporation’s capital structure, it becomes less likely that you will need to be paid taxable dividends. The corporation’s cash flow can be used to pay off the debt, and when the debt is paid off, you will own 100 percent of the corporation with a smaller investment on your part.
In addition, using third-party debt financing usually does not require giving voting rights to the lender, but taking on additional equity investors will generally result in your voting power being diluted.
If you can afford to provide all the needed financing, this problem can be addressed with an initial capital structure consisting partly of equity and partly of debt owed by the corporation to you (owner debt).
Including owner debt in the capital structure creates a built-in mechanism for withdrawing the debt part of your investment in a tax-free fashion, because the loan principal repayments are recovered tax-free by you.
Of course, you are taxed on the interest payments, but I assume that the corporation will get an offsetting deduction. So, the interest payments represent another way to get cash out of your C corporation without the threat of double taxation.
Once you decide to include owner debt in your C corporation’s capital structure, it becomes important to ensure that the debt will be respected by the IRS. Otherwise, the hoped-for tax benefits are lost.
Here are four commonsense factors that help make sure the IRS respects the debt classification:
The debt contains an interest rate and is recognized by a formal debt instrument signed by the corporation and the holder(s) of the debt.
The debt is recognized in the corporate books of account.
The debt instrument contains a maturity date and/or an installment payment requirement. With installment payment requirements, timely payments go a long way in establishing the debt. Thus, debt with required periodic payments is superior to a demand loan.
The debt is secured. With a demand loan that’s payable a good time in the future, a security interest helps legitimize that this is debt and not equity.