1. Home
  2. Taxes General Forum
  3. Debt versus Equity in a small C-Corp

Debt versus Equity in a small C-Corp

I have had a one-person C-Corporation for many years.

At times it has been successful, but it has had mostly losses for 4 or 5 years, which I have made up by advancing funds to the corporation.

The shareholder loan account, representing my loan to the corporation, is now up to about $50,000. (The capital stock is currently about $15,000).

The paperwork of paying interest and rolling over the loan every year is trying and might not ultimately be satisfactory to the IRS because it is a little rough. And of course the IRS might be concerned about "thin capitalization."

Should I just convert it all to equity? This would make everything a lot easier.

Originally, I made it mostly a loan, because I thought that there might be a problem later on withdrawing equity without paying taxes, once the corporation starts making profits again.

More recently though,one or two accountants have told me that withdrawing equity tax free would actually not in fact be a problem, other than that it might have to be timed right because withdrawals within a profitable year are going to be assumed to come from profits, not as a return of capital.

I would be able to handle that timing issue though, at that future time, because once the profits come again I can wait until the following year to withdraw the capital. I would be able also to eliminate profits for a future year if need be in order to return the capital in that year.

So, assuming that that timing issue can be handled when it arises, might it make sense to go ahead and convert the capital to all (or mostly) equity, to eliminate all of the hassles of rolling over the loan every year and paying interest etc.

I realize that nobody can give me actual advice, but am I understanding the basic issues correctly?

Or is there a risk that if I do convert it to all equity, that the IRS might later question its later tax-free return on some grounds, and try to tax it instead of treating it as a tax free return of capital?

Thanks for any thoughts!

Don

.
Reply to
Don Brady
Loading thread data ...

It might be better for the corporation to issue section 1244 stock (in return for money), so that if you sell the stock later, or dispose of the company, you can deduct the loss. Search the internet for "section 1244 stock".

I'm not too good with corporations but maybe you should have consulted with a professional. The corporation still has to pay taxes on its profits, and then from what is left in its bank account can pay back the loan. It should also deduct the interest paid as a business expense (thereby increasing the carryover loss), and you should report it as income on your individual Schedule B.

However I'm not sure that you have to charge your corporation interest. Charge 0% interest. The IRS will generate something called imputed interest, which is the minimum interest you should have charged (see the AFR rates at

formatting link
and the current rate is about 3% for long term rates). As this interest was not charged, it is considered to be a gift to the corporation. As long as the gift is less than the exclusion amount, which is 13k this year and less in earlier years, there is no gift tax for the donor to pay, and the corporation does not have to report the gift. But a gift to corporation is complex -- what if it's a foreign corporation, there are many shareholders, etc.

I'm not sure it matters where the money comes from as long as taxes were paid on it.

You've lost me.

Reply to
removeps-groups

That makes no sense.

Since OP has to pay income tax on the imputed interest anyway, why not collect it? Then he can *lend it back* to the corporation, avoiding the complete loss involved in just not collecting it.

But I'm not certain the imputed interest and gift tax rules apply to corporations the way you think (else I could set up a dozen corporations and each of them gets a $13K gift, completely destroying the concept of "limit" to annual gifts).

Seth

Reply to
Seth

Thanks very much for the comments and especially for the information about section 1244 stock.

I will be sure to record all stock issuances to take advantage of section 1244.

I think I have the whole issue under control at this point.

Don

Reply to
Don Brady

If the OP didn't charge interest then the OP does not have to report income on Schedule B as there was none. Neither can the person the money was lent do take a deduction for interest paid as none was paid. But the imputed interest is introduced for the purpose of figuring out how much gift tax to pay.

One should also mention that the OP's setup is strange. An S corp with one shareholder or single person LLC might be a better setup. Then this issue of loans might not even come up at all. But I'm no expert on this.

Reply to
removeps-groups

I thought that imputed interest also applied to income tax. That is to say that if someone accepted loan payments without interest, the contract would be re-formed to determine how much of the payment was interest and how much was principal, and each part treated accordingly.

___ Stu

formatting link

Reply to
Stuart A. Bronstein

BeanSmart website is not affiliated with any of the manufacturers or service providers discussed here. All logos and trade names are the property of their respective owners.