LLM Corporate Tax Instructor: Dwight Drake Debt-Equity Trade - Off All Equity Debt/Equity Assets 1,000,000 1,000,000 Debt 0 600,000 Equity: Capital 750, ,000 Retained Earnings 250, ,000 Total Equity 1,000, ,000 Earnings distributions: Dividend Interest Capital distribution: Dividend Loan Repay Return on equity of 150k operating income 15% 28.5% and 36k interest expense

LLM Corporate Tax Instructor: Dwight Drake Debt-Equity Factors 1. Documentation: Unconditional promise to pay; specified term; interest rate; default remedies 2. Debt/Equity Ratio: “Inside” and “Outside” debt. “Book value” v. “Market Value”. If ratio over 5-to-1 based on total debt and book value, must be able to show consistent profitability and cash flow will support debt. 3. Proportionality: Same ratio as stock ownership 4. Subordination: Inside debt inferior to outside debt 5. Convertibility: Debt convertible to stock

LLM Corporate Tax Instructor: Dwight Drake Chez Corp. Problem (a) A 300k five-year note Variable interest 40k cash + business (40k) for 100 shares 80k cash for 100 shares Bldg 80k for 100 shares Basis 20k B C Bank 900k loan 300k five-year note Variable interest 300k five-year note Variable interest (a) Issue: Will 900k shareholder debt be treated as equity for tax purposes? Consequences: Interest payments not deductible; all interest and principle payments taxed as dividends to extent of E & P. Factors: Form of debt (no problem); proportionality (problem); Debt- Equity ratio (problem – 12.85:1 (Cost); 7.5:1 (FMV)); Capacity to repay (?); intent to repay (?); subordination (?). Probably cooked here.

LLM Corporate Tax Instructor: Dwight Drake Problem Chez Balance Sheet Post Funding Cost FMV Assets: Cash 1,920,000 1,920,000 Building 20,000 80,000 Goodwill 0 40,000 Total 1,940,000 2,040,000 Liabilities Bank Loan 900, ,000 Shareholder Loan 900, ,000 Total 1,800,000 1,800,000 Equity 140, ,000 Total Liab. & Equity 1,940,000 2,040,000

LLM Corporate Tax Instructor: Dwight Drake Chez Corp. Problem (b) A 300k 20 year debenture Interest 0nly from profits 40k cash + business (40k) for 100 shares 80k cash for 100 shares Bldg 80k for 100 shares Basis 20k B C Bank 900k loan 300k 20 year debenture Interest 0nly from profits 300k 20 year debenture Interest 0nly from profits (b) No hope. Too long; bad form (Debenture?); squirrelly interest (like dividend); subordinated; flakey intent to repay.

LLM Corporate Tax Instructor: Dwight Drake Chez Corp. Problem 153-1(c) A 300k five-year note Variable interest 40k cash + business (40k) for 100 shares 80k cash for 100 shares Bldg 80k for 100 shares Basis 20k B C Bank 900k loan unsecured 300k five-year note Variable interest 300k five-year note Variable interest (c) Bank loan may also be equity if corp thinly capitalized, unlikely corp can pay back debt, and bank expects ultimate repayment from shareholders. Guarantee itself won’t kill given prevalence of shareholder guarantees in private businesses. Need more facts here. Personally Guaranteed

LLM Corporate Tax Instructor: Dwight Drake Chez Corp. Problem 153-1(d) A 900k five-year note Variable interest 40k cash + business (40k) for 100 shares 80k cash for 100 shares Bldg 80k for 100 shares Basis 20k B C Bank 900k loan (d) Much safer because no proportionality. But 385 Regs. would have subjected non-proportional loan to proportional scrutiny if made by over 25% shareholder and had debt-to-equity ration over 10:1 (based on cost).

LLM Corporate Tax Instructor: Dwight Drake Chez Corp. Problem 153-1(e) A 900k five-year note Variable interest 40k cash + business (40k) for 100 shares 80k cash for 100 shares Bldg 80k for 100 shares Basis 20k B C Bank 900k loan (e) Failure to pay can trigger reclassification as equity if there is no effort made to enforce rights under default. 385 Regs. required “second look” if debt not paid. What to do? Renegotiate based on market standards and then properly document. Chez default in year 3

LLM Corporate Tax Instructor: Dwight Drake Problem Given vagueness, how to advise: 1. Carefully draft to avoid any hybrid stock attributes. 2. Market interest rate, term, maturity and payment terms. 3. Avoid proportionality and subordination, if possible (often not). 4. Manifest intent to repay (terms, remedies, maybe even security). 5. If possible, keep total debt/equity ration under 10:1 and inside under 3:1 (the 385 Reg safe harbors). 6. Make sure payments are made.

LLM Corporate Tax Instructor: Dwight Drake Hi-Tech Corp. Problem 157 (a) A 200k cash Secure, growth, tax smart 400k cash for 50% shares T J 400k cash for 50% shares a) 200k unregistered 5 yr note, market rate interest. No upside potential. Since not registered and no coupons, not security under 165(g). Hence, loss subject to 166, which permits ordinary loss if it “business bad debt” incurred in Jennifer’s trade or businesses. If non-business, then short-term capital loss. Key factor is that business, not investment, must be dominate motive. Need info: Was J employee of Hi-Tech, in business of loaning money, or had need to protect business relationship with H-Tech? If no, then STCL treatment.

LLM Corporate Tax Instructor: Dwight Drake Hi-Tech Corp. Problem 157 (b),(c),(d) A 200k cash Secure, growth, tax smart 400k cash for 50% shares T J 400k cash for 50% shares b) 200k registered bond. Still no upside. Since registered, is “security” under 165(g). If J hold a yr. as capital asset, loss will be LTCL. c) 190k registered bond with warrants to purchase stock (warrant cost 10k). Both bonds and warrants “securities” under 165 – LTCL treatment. d) 200k common stock. Per 1244, 50k (100K if married) of worthless stock loss may be ordinary; then rest LTCL. For 1244, J must be original issuee; stock issued for cash; aggregate amount corp received for stock not over 1 mill; corp receives over 50% of receipts from non-passive investment sources.

LLM Corporate Tax Instructor: Dwight Drake Hi-Tech Corp. Problem 157 (e) thru (h) A 200k cash Secure, growth, tax smart 400k cash for 50% shares T J 400k cash for 50% shares e) 200k convertible preferred stock. May qualify for 1244 treatment as described in d), a 1984 change in the law. f) Common stock to Jennifer, original shareholders capitalized for 1 mill. No 1244 treatment available to Jennifer. Stock loss capital loss pursuant to 165(g); g) Common stock to Jennifer, who gives stock to son. Gift would kill Only original issuees. h) Purchase common stock through partnership. Partnership may qualify for 1244, passing through to each partner.