Discussion:C-Corp Interest Payment to 100% Shareholder
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ConservativeDC (talk|edits) said: | 31 January 2006 |
| Can a C-corporation set up the following arrangement:
A 100% shareholder lends $10,000 to his corporation. The note dictates a simple interest payment of 100% per year, with principle payments made at the discretion of the corporation. Each year, so long as the corporation has the outstanding loan, it pays the shareholder $10,000 in interest. This is deductible to the corporation and taxable to the shareholder. The corporation issues a 1099-INT and reports the interest payment in Box 3 every year. I've never done something that aggressive, but I can't seem to find any pushback in the IRS publications on this. It would seem to be a good way to get around the double taxation of dividends and the FICA implications of a salary. | |
| 31 January 2006 | |
| The debt vs. equity issue is not likely to be discussed in Publicaton 17. This areas of the law is generally found in case law. For example, see KRAFT FOODS COMPANY v. COMMISSIONER OF INTERNAL REV., 49 AFTR 862 (232 F.2d 118), (CA2), 04/02/1956.
The substance over form doctrine prevails here. If the debt is really equity, the interest deduction will be denied. | |
ConservativeDC (talk|edits) said: | 31 January 2006 |
| Wow. You don't have to be so snooty about it. The publications I was referring to were 535 (business expenses), 542 (corporations), as well as the instructions to Form 1120.
After looking at the "substance over form" doctrine from that case, it seems to me that such a transaction would clearly be reconstituted as a dividend if subjected to IRS scrutiny. However, the downside to this is minimal for a corporation and a taxpayer both in the 15% bracket. Under the arrangement, the corporation takes the interest deduction at 15%, and the shareholder pays income tax at 15%. Net tax: 15% Suppose this is disallowed and instead is called a dividend. The corporation cannot deduct the dividend paid and must pay 15% tax on it. The shareholder has his tax rate reduced from 15% to 5% (0% in 2008). Therefore, there isn't a great deal of tax evasion going on here. It isn't as if a 35% corporation is paying interest to a charity or something. | |
| 31 January 2006 | |
| Would the usery laws come in to play? I seem to recollect there is a cap on an interest rate that can be charged, unless you are in the business of lending (aka a credit card company, financial institution, etc..) | |
| 1 February 2006 | |
| State usury laws which limit the rate of interest on a loan can have the effect of making the arrangement illegal; however, the courts have allowed deductions for interest paid on usurious notes. The presence of a usurious rate of interest is one indicator of equity vs. debt in the substance over form analysis. | |
| 1 February 2006 | |
| We need more information. Does the corporation have retained earnings and how much? Where is the cash coming from to pay the interest? Does the shareholder receive a current salary or have we got a personal holding company issue here? Why do we need to have the shareholder loan the money if the corporation can afford to pay the 100% interest? If we have significant retained earnings, why not just pay a dividend and have the shareholder pay the 15% tax? | |
| 2 February 2006 | |
| I think the point is that having it characterized as interest instead of a dividend apparently avoids the double taxation. I say “apparently” because this only works as long as the Service does not assert that the debt is really equity.
Starting in 2009, the 15% favorable tax rate for dividends will be eliminated. Consequently, the Service will have a stronger incentive to reclassify interest payments from thinly capitalized corporations back to dividends. | |
Jessijames (talk|edits) said: | 3 February 2006 |
| Hi everyone,
I enjoy reading all the points and questions. If the corporation has a legitimate reason for borrowing the money, i.e. purchase of equipment, or captial improvements, then in my mind the way to handle this would be: Set up promissory note for $100,000. with terms of 10% interest, with monthly payments of $1000.00 per month. The payments could be a $1,000.00 per month, thereby reducing principal a some amount each month. In this case the interest would be deductible. Evaison should never be a consideration, if it has any indicator that this is the purpose of the action, then the action should not be taken. Another, question that was also raised earlier, is your shareholder collecting a salary, because this has become a major issue for the IRS. Again, enjoy the input. All take care | |
ConservativeDC (talk|edits) said: | 4 February 2006 |
| One of the issues is that there are any number of ways that a corporation can compensate shareholders and avoid double-taxation. This would include:
1. Salary. The problem here is that FICA taxes can be prohibitive relative to the other options. 2. Ordinary and necessary business expense reimbursement. 3. Tax-free fringe benefits (for employees). 4. Interest owed to a shareholder for what he loans to the corporation. 5. A consulting fee paid to a shareholder (which brings up SECA issues). 6. Rent paid to a shareholder for corporate use of shareholder property. Am I missing anything here? It seems to me that if the goal is avoidence of double taxation (and, implied in that, avoidence of FICA/SECA as well), the best courses of action (besides expense reimbursement and fringe benefits, which are kind of a separate matter) would be interest and rent. There have been many significant objections posted on the debt vs. equity question, which is new to me. I know that there are also prohibitions against an employee taking rental expenses against rental income from his employer, so that would be an issue to get around. Thoughts? | |
| 5 February 2006 | |
| You cannot use equity disguised as a debt instrument as a “device” to distribute earnings and profits.
The Ninth Circuit has listed 11 factors that should be considered in determining whether a debt instrument is really an equity instrument (stock). Other circuits use a shorter list. However, a usurious interest rate is one of the factors that the courts will examine when deciding to reclassify debt to equity. | |
| 31 March 2007 | |
| A little off-topic, but wouldn't #5 be 1099-MISC income, subject to SE tax anyway, so no savings? Same for corp dir payments?
As regards the 100% interest, I don't think it passes the laugh test - can you make the argument to the IRS or a judge with a straight face? 18% interest, sure, 100%? Seems to me the corp. would look elsewhere for financing, e.g., biz line of credit, rather than pay 100% interest. | |
