A CORPORATION'S CAPITAL STRUCTURE should be designed, when possible, to allow corporate cash to be withdrawn without incurring double taxation. At first glance, it might seem that a minimal amount of stock should be issued, with the bulk of the corporation's capital coming from shareholder loans (to make corporate distributions either deductible interest expense or tax-free principal repayments). Within reason, this is a good approach. However, the IRS is likely to challenge capital structures when the equity is "thin" in relation to the debt, particularly when that debt is attributed to controlling shareholders who hold debt and stock in the same proportions.
In addition, the corporation's future capital needs, and its ability to service the debt in light of these needs, must be considered. There will still be a net tax cost from interest paid to the shareholders when their marginal tax rates are higher than that of the corporation. Having large shareholder debt can also adversely affect the corporation's ability to obtain outside financing.
Maximizing Bad Debt Deduction on Shareholder's Loan to a Corporation
Business bad debts are fully deductible in the year they become partially or entirely worthless (Secs. 166(a)). This is typically preferable to the tax treatment of nonbusiness bad debts, which are deductible as a short-term capital loss in the year the debt becomes totally worthless. A business bad debt occurs when:
The debt generating the loss was created or acquired in the course of the taxpayer's trade or business (e.g., as trade receivables); or
The worthless debt is incurred in the trade or business of the taxpayer (Sec. 166(d)(2); Regs. Sec. 1.166-5(b)).
Determining a taxpayer's trade or business is important in analyzing business versus nonbusiness debts because a business bad debt must be created in, or related to, the taxpayer's trade or business. Case law has established that the business carried on by a corporation is not considered the business of a shareholder simply because of the corporation-shareholder relationship. However, a corporation may carry on the same business as a shareholder, or they may be involved in related businesses.
Case law has also determined that being an employee is a trade or business (Trent, 291 F.2d 669 (2d Cir. 1961)). A shareholder's loan that is closely related to the shareholder's trade or business as an employee will qualify as a business debt. However, a loan...