Issuing third-party debt to raise additional capital.

• Author: Ellentuck, Albert B.

In many cases, a corporation reaps tax advantages if it issues debt, rather than stock, to investors, because interest paid on the corporation's debt is deductible, while dividends paid to shareholders are not. Further, the creditor receives principal repayments on corporate debt tax free, while distributions to shareholders are normally taxable as dividends to the extent of earnings and profits. The bias for issuing corporate debt and against capitalizing the corporation with equity (i.e., stock) has not changed due to recent legislation. (When it is not possible to use debt due to business reasons, the disadvantage of using equity is reduced, because qualified dividend income is currently taxed at a maximum 15% rate.)

If third-party debt is used as part of the initial capital structure, the shareholders do not need to invest as much of their personal funds, but can still obtain the same amount of ownership and control. Because less of the shareholders' money is invested, there is less likelihood they will need to take cash withdrawals that might be dividends to them and nondeductible by the corporation. The third-party loans can be repaid with cashflow generated by the business. Also, these repayments will not affect the shareholders' ownership interests and voting rights.

Example 1

Mary Jones contributed $100,000 to her new corporation, MJ Inc. The corporation borrowed an additional $200,000 in capital from Mary's friend, Stan Smith, to operate the business. Stan insisted on a market interest rate of 8% and monthly payments that will result in full repayment over 10 years.

Even though MJ incurred substantial interest expense over the 10-year period, it was able to fully repay the $200,000 debt. By leveraging capital with outside debt, the shareholder's rate of return on capital exceeded the 8% interest rate paid on the borrowed funds. Mary now owns 100% of all MJ's stock, with a personal investment of only $100,000. This option is clearly preferable to providing other individuals with stock that has voting rights or dividend preferences. Of course, the difficulty lies in finding an outside party willing to loan funds to a start-up company.

Outside investors holding corporate debt and equity have the advantage of being creditors in the case of bankruptcy or liquidation, while still maintaining an equity interest in case the venture is successful. Shareholder-creditors are on an equal footing with other creditors if the corporation goes...