Corporate Income Tax & Undistributed Corporate Income

Corporate Income Tax and Undistributed Corporate Income Business Attorney

Corporate income tax and undistributed corporate income are issues for business owners and their tax attorney and/or business attorney.

Corporations have been taxed by the United States government since 1909 under the Payne-Aldrich Tariff Act.  Internal Revenue Code Section 77010(a)(3) includes associations and joint stock companies within the definition of “Corporation.”  Thus, federal corporate income tax is imposed on corporations that do not constitute a corporation under state law.  Certain corporations known as S Corporations that are pass-through entities are not taxed at the corporate level, but rather at the shareholder level as profits, losses and other items are passed through to the individual shareholders.

Although, exceptions exist, a corporation’s taxable income is computed in very similar fashion to that of an individual.  Generally, the major difficulties do not arise in computing a corporation’s taxable income or tax liability, but because, distributed income is taxable to the shareholder(s) and undistributed is not; an exchange of stock or securities may or may not lead to the recognition of gain; certain sales may actually be a dividend (disguised dividends); and, considerations regarding arm’s length transactions between a corporation and the corporation’s shareholders.  These are issues that should be discussed with your tax attorney or business attorney.

The Internal Revenue Code treats corporations as independent taxpayer’s and therefore a corporation is taxed on corporate income as it is received or accrued.  However, the shareholders of the corporation are taxed only when (and if) corporate distributions are made, or stock is sold.  Therefore, at times, it could have been beneficial to operate as a corporation as opposed to a sole proprietorship or other entity if the corporate tax rates were less than the individual tax rates.

More current laws have increased the corporate income tax rate, and under certain sections of the Internal Revenue Code, the IRS has a variety of means by which to exploit corporate income that has been insulated or undistributed to shareholders.  I.R.C. Section 482 allows the IRS to reallocate gross income, deductions, credits and other allowances between 2 or more business entities or organizations that are under common control so that income is clearly reflected.  Furthermore, I.R.C. Section 531 allows an accumulated earnings tax to be imposed by the IRS on undistributed corporate income, when the failure to distribute income is deemed for the purpose of avoiding tax.  Generally, the IRS would look to see if the corporation had accumulated earnings beyond the reasonable need of the corporation.  Additionally, I.R.C. Section 541 imposes personal holding company (PHC) tax on undistributed income within a PHC.

Due to changes of tax rates and the above code sections, use of the C Corporation can make less sense depending upon the taxpayer’s overall circumstances.  Often the choice to operate as a C Corporation is by default because the entity must operate in the C Corporate form, and/or is ineligible to make the S Election with Form 2553 and operate as an S Corporation.

This article has been drafted by John McGuire.  John is a business attorney and tax attorney at The McGuire Law Firm.  When deciding upon your choice of entity, or if you have questions regarding entity taxation, please feel free to contact a Denver tax attorney or business attorney at The McGuire Law Firm.

Schedule a free consultation with a Denver tax attorney at The McGuire Law Firm!

Compensation Planning: Types of Qualified Plans by Denver Tax Attorney

Compensation Planning: Types of Qualified Retirement Plans Denver Business Attorney

Compensation planning can be very important for business owners both individually and as a means by which to maintain the services of employees.  As a Denver business attorney and tax attorney, John McGuire works with businesses to create and implement compensation plans.  A Denver tax attorney can also assist you with the tax implications of certain plans and other tax issues.

There are multiple types of qualified retirement plans that can be submitted to the IRS for qualification.  A qualified plan is a plan that has met the requirements of the code, regulations and other pronouncements to receive tax exempt status.  The most important tax advantages of a qualified plan are: 1) the employee does not include in their gross income their interest in the employer contribution or the income earned by the trust fund until the employee receives funds from the plan; 2) the employer may deduct contributions to the plan; 3) the earnings of the plan are exempt from tax while held in the trust; 4) certain distributions may be eligible for special income tax treatment.

Defined Benefit Plans

Defined benefit pension plans are plans where the employer provides payment of definite and determinable benefits to employees over a period of years.  Usually benefits are paid to employees for their life after retirement.  The benefits received by the employees in retirement are usually measured by factors such as years of service to the employer and compensation received by the employer.  There are three general types of defined benefit plans: 1) Fixed benefit formula providing a fixed amount of benefits that is unrelated to years of service by the employee or the employee’s earnings and compensation 2) Flat benefit formula providing retirement benefits equal to a fixed percentage of the employee’s salary regardless of the time of services; and 3) Unit benefit formula that provides the employee with retirement benefits at a specific percentage of each years average or actual compensation paid to the employee multiplied by the years of service.

Under ERISA the employer is usually required to make annual payments into the trust that would be necessary to fund the benefits.  The benefits of the plan are partially guaranteed by the Pension Benefits Guaranty Corporation.  Defined benefit plans promise employees very specific benefits at retirement.  No individual accounts are created for the individual employees and no assets are separated from within the plan.

Defined Contribution Plans

Defined contribution plans hold individual accounts for each participant in the plan and for benefits based on the amount the participant contributes to their account.  There are three types of defined contribution plans: 1) Profit sharing plans are established and maintained by employers providing a share of the employer profits with employees.  Contributions can be determined by the employer or based upon a fixed equation or formula.  The plan must provide a specific pre-determined equation or formula for the allocation of contributions that are made to the plan by the plan participants; 2) Stock bonus plans are established and maintained by the employer providing similar benefits to a profit sharing plan, but the benefits are distributable in stock of the employer company; 3) Money purchase plans are a defined contribution plans with individual accounts similar to profit sharing plans.  The amount of the annual contribution is determined by applying a specific equation or formula.

Employers considering the creation of a qualified retirement plan should consult with their business attorney and tax attorney regarding their obligations to the plan and the tax implications to their business.

Contact The McGuire Law Firm to speak with a business attorney or tax attorney


The Varying Interest Rule & IRC 706

The Varying Interest Rule and I.R.C. § 706 Denver Tax Attorney

            If you are considering transferring a partnership interest or admitting a new partner to a partnership, considerations need to be made regarding the allocation of each partner’s distributive share.  A Denver tax attorney we assist you and your partnership in understanding the Varying Interest Rule and other partnership issues.  Although, such issues are discussed briefly below, it is recommended that you contact your tax attorney or business attorney to discuss these issues and how they relate to your circumstances.


If a partner transfers their partnership interest, or a partnership admits a new partner(s) based upon the new partner’s contribution of capital, a shift in the partner’s interest will occur.  This shift in interest creates issues regarding the closing of the partnership’s taxable year, the allocation of partnership items between the transferor and transferee, and retroactively allocating items to the incoming or “new” partner.  The closing of the partnership taxable year is governed by I.RC. § 706(c) and § 706(d), the varying interest rule, governs the allocation of each partner’s distributive share.  Although, the substantial economic effect doctrine under I.R.C. § 704(b) can also impact the allocation of a partner’s distributive share, the substantial economic effect doctrine and related issues will not be discussed in this article.


Under §706(c)(1), except upon the termination of the partnership, the partnership’s taxable year does not close upon the death or entry of  a partner, the sale or exchange of a partner’s interest or the liquidation of a partner’s interest.  However, under 706(c)(2), the taxable year of a partnership does close with respect to a partner whose entire interest in the partnership terminates due to death, liquidation or another reason.


When partners interest in the partnership change during a taxable year, the partner’s distributive share of partnership income, gain, loss or deduction are determined by taking into account the partner’s varying interest in the partnership during the taxable year.  I.R.C. §706(d) applies to changes amongst partner’s interest during the taxable year.  These changes include sales, partial sales, gifts and reductions in the partner’s interest.  Under the code, cash basis partnerships are also forbidden from deferring certain payments for deductible items until the end of the year.  For example, if a new partner was admitted on December 1st, and rent for the entire year was paid December 15th, the newly admitted partner may not be able to receive the benefit of the entire years rent payment as they were only a partner for one month of the taxable year.  Additionally, under I.R.C. 706(d)(2)(D), when items are attributable to periods of time prior to the beginning of the tax year and are later assigned to the first day of the taxable year thereafter, such items should be allocated to the partners who were partners during the period of time each item is attributable.  If any partner is not a partner when the item is being allocated, this partner’s portion of the item should be capitalized by the partnership and allocated to the basis of the partnership assets under I.R.C. §755.

As a Denver tax attorney and business attorney, John McGuire works with partners and partnerships regarding the issues discussed above and other partnership issues.  Please feel free to take advantage of our free consultation at anytime.

Schedule a free consultation with a business attorney by contacting the McGuire Law Firm.

Stock v. Debt Classification Issues

Stock v. Debt: Classification Issues

Denver Business Attorney

Classification issues commonly exist regarding debt versus stock treatment.  John McGuire, as a Denver business attorney and tax attorney assists individual investors and businesses regarding this issues.  Hopefully, the article below provides useful information.

Substance over form is used in determining whether an instrument received by an investor in exchange for property contributed to a corporation is treated as stock or debt.  Thus, the title of “stock” or “debt” alone by the corporation or individual is not necessarily determinative or controlling of the treatment for income tax purposes.

Currently there is no definition in the Internal Revenue Code to determine when an interest in a corporation constitutes debt and when an interest constitutes stock.  Therefore, determining how an interest should be labeled and the tax implications is derived through case law as the courts attempt to determine if the investment or instrument more closely resembles a true debt interest or true equity interest.

A debt interest is defined as: a written unconditional promise to pay a principal amount, on demand or before a fixed maturity date, within a reasonable time in the future, with interest payable in all events and no later than maturity.  An equity interest is defined as: an investment which places the funds contributed by the investor at the risk of the business, provides for a share of future profits of the business, and gives rights to control or mange the business.

Although courts has established a number of factors and criteria to determine and differentiate between debt and equity interests, no single factor or set of factors allows for a completely accurate and universal determination.  Thus, the factors only aid in the interpretation.  Each case must be analyzed separately by weighing the facts & circumstances of the case.


The “thinness” of a corporation’s capital structure refers to the ratio of debt to equity.  When far more debt has been invested than equity, a corporation is referred to as “thin” and lacking equity contributions from shareholders.  Due to the fact a debt to equity ratio can be viewed somewhat subjectively and mechanically, it has been used to create statutory rules that would disallow interest deductions.  Issues however, remain such as should only shareholder held debt be included when calculating the ratio, and regarding equity, is market value or tax basis used?

I.R.C. Section 385

Enacted in 1969, IRC Section 385 authorized the U.S. Treasury Department to promulgate regulations governing the determinations of stock v. equity interests in corporations.  The Treasury issued proposed regulations multiple times that were to become final, but after criticism, the regulations were never finalized and have yet to be.  It appears that boiling down this complex matter into working rules and regulations is a daunting task, and the Treasury, for the time being has moved on to other issues and interests.

I.R.C. Section 163(e)

IRC Section 163 applies to a debt instrument issued at a large discount and thus reflects an unreasonably high interest rate.  The large or excessive portion of the discount is deemed and treated as a dividend, and not interest to the investor/recipient and the payor (corporation/entity) is disallowed a deduction for the excessive amount.

This article was prepared by John R. McGuire.  John is a business attorney and tax attorney who works with individuals and businesses regarding individual and entity income tax matters to the sale and purchases of businesses.  At The McGuire Law Firm a Denver business attorney and tax attorney can assist you with the formation and structure of your entities including debt & equity issues.

Contact The McGuire Law Firm to speak with a business attorney or tax attorney.

Formation of the Partnership: Contribution of Property & Basis by Denver Tax Attorney

Formation of the Partnership: Contribution of Property & Basis Denver Business Attorney

At The McGuire Law Firm a Denver tax attorney and business attorney can assist clients with the formation of their partnership and the tax consequences based upon the property contributed by the partners.  The article below has been drafted by a tax attorney may be useful when property is contributed to a partnership for a partnership interest.

When a partnership is formed, the partners will generally contribute property to the partnership.  Under Internal Revenue Code Section 721, the partners will recognize neither gain nor loss when they contribute property to the partnership in exchange for a partnership interest.

There are exceptions to IRC Section 721.  The non-recognition rule of Section 721 does not apply to, the receipt of an interest in partnership capital in return for services that are performed for the partnership or for services to later be rendered, and when the deemed money under IRC Section 731(a)(1) exceeds the sum of the adjusted basis in the property contributed.  Further, Section 721 would not apply to a disguised sale under IRC 707(a)(2)(B) where a partner contributed property and received a priority distribution of cash and property within 2 years from the time the original contribution was made to the partnership.  You must always consider whether the value of the property contributed is equal to the value of the partnership interest received by the partner.

What constitutes property for purposes of IRC 721?  Property includes both tangible (money, personal property & real property) and intangible property.  Intangible property would be goodwill, contract right, accounts receivable, patent rights, secret processes and other types of intangible property, but the property must be owned by the partner who transferred the property (transferor) on their own behalf.  When looking at property transferred to a partnership, if the property has value separate and apart from the partnership, the property should be considered Section 721 property.

What is the partner’s basis?  When a partner contributes property in exchange for a partnership interest, the partner’s basis is the amount of money contributed and the adjusted basis of the property contributed.  Thus, a partner receives a carryover basis in their partnership interest for the property they contribute.

When a partner receives a partnership interest for services performed, this service partner’s basis in their partnership interest is the sum of money paid by the partner for their partnership interest and any amount included in income in connection with the interest transferred.  This recognition of income will only increase the partner’s basis in the partnership if the gain resulted from the non-applicability of Section 721.

What is the partnership’s basis in the contributed property?  The partnership’s basis in the property contributed would be the adjusted basis of the property in the hands of the contributing partner under IRC Section 723.  The contributing partner’s basis would be measured or calculated at the time the partner made the contribution to the partnership.

This article was prepared by John McGuire at The McGuire Law Firm.  John is a tax attorney and business attorney working with individuals and businesses regarding their tax and business matters.  A Denver tax lawyer and business lawyer at The McGuire Law Firm can assist you regarding the formation of partnerships, tax implications of partnership contributions & distributions and partnership transactions.

Contact The McGuire Law Firm to schedule a free consultation with a tax attorney or business attorney!

Simplified Employee Pension (SEP)

Denver Business AttorneysSimplified Employee Pension (SEP)

Certain individual retirement accounts or individual retirement annuities may qualify as a simplified employee pension (SEP).  Under a SEP each employee’s contributed funds are placed in an individual retirement account (IRA) that the employee controls as an investment and the distributions.  Our tax attorneys in Denver have helped many individuals understand the tax implications of a SEP and other retirement vehicles.  The article below should act as a general guide to understanding a SEP.  If you have questions, please contact a Denver tax attorney at The McGuire Law Firm.

Under IRC Section 408(k), SEP individual retirement accounts have five characteristics: Contributions may not discriminate in favor of highly compensated employees; the SEP must be an individual retirement account or individual retirement annuity; the employer must make contributions to the SEPs of all employees; employees must be allowed to withdrawal portions without penalty imposed by the employer; and, the employer contributions must be allocated to the SEPs of the employees per a written formula specifying how the contribution is to be divided and how much each of the contribution an employee may expect to receive.

If the SEP is established using an IRS form or certain information is provided to eligible employees, the employer may qualify for relief from reporting and disclosure requirements otherwise required by ERISA.  Generally, this relief would come in the form of not being required to file Form 5500 as well preparing and distributing a plan description and summary to employees.

A SEP may only be established by an employee.  Thus, an individual must first be an employee and under a SEP arrangement or plan before an IRA can be used as a SEP.  A sole proprietor may establish a SEP because they are treated as their own employer.  Further, a partnership can establish a SEP as the partners are considered employees of the partnership under IRC Section 408.

A SEP requires a written document executed by the employer, which must be in place by the latest date allowed by law for employer deductible contribution.  This is an advantage to other qualified plans under IRC Section 401.  For example, Joe could create a SEP arrangement and contribute to the SEP on or before April 15, 2009 for the 2008 tax year.  However, an IRC Section 401 qualified plan would need to be executed by December 31, 2008.

The written SEP arrangement must include four elements: the name of the employer, the requirements for an employee to receive an allocation or share of the employer’s contribution; the equation for allocating the employer’s portion amongst those employees that are eligible; and, a responsible officer must sign the written document.  The written instrument requirement can be satisfied by the employer filing Form 5305-SEP.

An employer considering the creation of a SEP should obtain information from their tax attorney, business attorney and/or financial advisor regarding the requirements and tax implications to their business.  A Denver tax attorney or business attorney at The McGuire Law Firm would be happy to assist you with any questions you may have.


Contact The McGuire Law Firm to schedule your free consultation with a Denver tax attorney or business attorney.

Corporate Earnings & Profits

Corporate Earnings & Profits Denver Tax Attorney

A tax attorney at The McGuire Law Firm can assist your corporation regarding corporate issues such as earnings & profits, and what this term means to their business.  A tax attorney can help individual business owners regarding certain transactions of which the corporate earnings & profits will play a role.  Below is an article related to corporate earnings & profits that we hope you find useful.

From a tax perspective a corporation’s earnings & profits (E&P) do not impact the corporation’s tax liability.  Thus, why is the E&P of a corporation important, and what impact does such amount of figure have on the corporation?  The reason corporate E&P is so important is because a corporation’s E&P is used to calculate how distributions to shareholders of the corporation are taxed.  Corporate distributions are included in a shareholder’s gross income for individual income tax purposes to the extent the distribution constitutes a dividend under IRC Section 301.  Internal Revenue Code (IRC) Section 316 defines a dividend as any distribution of property from a corporation to the corporation’s shareholders out of E&P.

Corporate distributions are first treated as a dividend to the extent of the corporation’s E&P.  Thereafter, the distributions are treated as a return of capital to the shareholder(s), and thereafter capital gain to the shareholders.  Thus, a corporation’s E&P really appears to be a measure of the corporation’s ability to make distributions to the corporate shareholders without returning the shareholder’s capital contribution or other investor investments. This means a corporation’s E&P is a measure that represents a corporation’s ability to make distributions to shareholder’s without disrupting the shareholder(s) basis in their capital investment.


There is no black and white rule, method, statute or law for a corporation to follow when calculating E&P.  Due to the important role E&P plays in characterizing corporate distributions as dividends, the allocation of E&P in tax free corporate distributions such as reorganizations are important considerations when corporations consider such transactions and reorganizations.  IRC Section 381 deals with the carryover of corporate E&P.  For example, what occurs when one corporation with an E&P deficit is acquired by a corporation with accumulated E&P?  The IRS has issued regulations section 1.312-10 to address these issues, which will not be discussed in this article.


Under IRC Section 302 certain corporate distributions may not be treated as dividends and thus be given sale or exchange treatment to the taxpayer.  These transactions are primarily based on the overall impact to the shareholder’s ownership in the corporation after the transaction has been completed.  If a shareholder’s corporate ownership has been reduced or diminished enough, the distribution to the shareholder can be afforded sale or exchange treatment.  If the shareholder, after the transaction no longer holds any stock and has completely liquidated their interest, the transaction may be afforded sale or exchange treatment.  Certain transactions may also be considered partial liquidations and thus receive sale or exchange treatment.

Corporations with questions regarding their E&P, or considering distributions of property should consult with their CPA and/or their tax attorney and business attorney to discuss the tax implications to the corporation and shareholder. A Denver tax attorney or business attorney at The McGuire Law Firm would welcome the opportunity to discuss such tax matters and issues with any business owner.

You can schedule free consultation with a Denver tax attorney by contacting The McGuire Law Firm.  720-833-7705 or

Offices in Denver, Colorado and Golden, Colorado.

C Corporation Considerations When Selling Your Business

C Corporation Considerations When Selling Your Business Denver Business Attorneys

As a business and tax attorney, John McGuire at The McGuire Law Firm is commonly asked, “how should I sell my business, and what are the tax implications?”  This question brings about many issues; way too many to be discussed in a short article, but the owners of a C corporation should understand the basics behind a stock sale versus and asset sale and the advantages and disadvantages to each.

When the business owner is considering the sale of their business they must determine whether they wish to sell the stock or the assets of the business.  A shareholder or seller would usually prefer a stock sale and a buyer would usually prefer an asset sale.  When the stock of a C corporation is sold sale or exchange treatment is given to the transaction and therefore the shareholder will receive capital gain treatment on the amount received above the basis in their stock.  The buyer prefers an asset sale because the purchase of the assets allows for a step up in basis, and the buyer does not carryover the seller’s depreciation schedule.  This generally will afford the buyer greater deductions and less tax.  Furthermore, when the stock of a corporation is purchased, the seller is relieved of liabilities and liabilities or exposures to such are transferred to the buyer.

The above issues show why the sale of C corporation assets is not favorable due to the fact there are not capital gains rates for corporations.  A C corporation selling appreciated assets will pay corporate level tax even if a capital gain is generated.  If cash is distributed to the shareholders after the sale of corporate assets, this is also a taxable event likely to be treated as a dividend or receive capital gains treatment.  Regardless, double taxation has occurred.

A C corporation may be able to mitigate some or all of the double taxation based upon the current tax attributes of the corporations.  For example, the corporation may have a net operating loss or certain credits that carry forward.

Any business considering liquidating or the sale of stock or assets should contact their business attorney and/or their tax attorney to discuss the full implications of the transfer.  A Denver tax attorney or business attorney at The McGuire Law Firm can assist you with your tax or business questions or issues.

Contact The McGuire Law Firm to schedule a free consultation with a tax attorney or business attorney.

Partnership Special Tax Allocations

Special Tax Allocations Denver Business Attorney

The special tax provisions included in the majority of partnership agreements such as limited partnership and limited liability company (LLC) operating agreements, exist to satisfy requirements regarding the regulation of partnerships as established within the Internal Revenue Code.  These special allocation provisions can alter the bargained for agreement and understanding of the partners thus, creating disruption between the partners during the operation of the partnership.  A Denver tax lawyer at The McGuire Law Firm can assist partners and partnerships in understanding the impact of special tax allocations.

The Internal Revenue Code allows a partnership to have flexibility regarding the partner’s pass through of income and loss.  However, Internal Revenue Service will not respect allocations that do not have substantial economic effect.  In short, substantial economic effect means that partnership allocations need to be passed through to the partners who receive or enjoy the benefit of the income or hold the economic burden associated with the partnership losses.  The IRS can reallocate income or losses if the IRS determines an allocation or allocations do not have substantial economic effect.

The impact on the substantial economic effect regulations may be most apparent when looking at the limited partners in a limited partnership (or limited liability company).  The benefit of limited liability can result in certain allocations lacking substantial economic effect in the eyes of the Internal Revenue Service.  When considering the special allocations within a partnership agreement, one should note that a safe harbor is provided and can be satisfied in the partnership agreement with the inclusion of certain provisions as outlined below.

Non-Recourse Debt Allocations: Such provisions require that the allocation of losses and deductions to partners associated with non-recourse debt-financed property have substantial economic effect.

Partner Minimum Gain Chargeback: Such provisions apply when there are non-recourse liabilities that a partner bears the risk of economic loss.  The minimum gain related to these liabilities need to be allocated to partners that previously received allocations of losses and deductions related to the applicable liabilities.

Distribution Triggered Special Allocations: Such provisions allocate gain and income to a partner that offset “excess” distributions received by the partner that would be in excess of the partner’s interest.

It is recommended that the partners or partnership consult with a business attorney or tax attorney to discuss the impact of special allocations and to draft the operating agreement of the partnership.  The reallocation of income, loss, gain or deductions by the IRS can create negative individual income tax consequences to the individual partners.  Our tax attorneys and business attorneys are available to consult you regarding these issues.

Contact The McGuire Law Firm to speak with a Denver tax attorney or business attorney.  Free consultation!

The Corporate Capital Structure

The Corporate Capital StructureDenver Business Attorneys

At The McGuire Law Firm, a Denver business attorney or tax attorney can assist you with the capital structure of your corporation and other business entities.  The article below is a general outline of some issues to consider when looking at your corporate capital structure.  Please feel free to contact a Denver tax attorney and business attorney at The McGuire Law Firm.

When forming a corporation, the capital structure should be designed in a manner that effectively allocates the various interests in the corporation amongst the owners and investors.  The pertinent interests will be: interests in current income, interests in control and, interests in accumulated income and capital.  When organizing the corporation, there is significant flexibility to design the capital structure and thus accomplish the preferred allocation.

The capital structure of a corporation will consist of securities issued by the corporation in exchange for cash, property or services contributed to the corporation.  Stock issued by the corporation represents ownership in the corporation or an equity interest in the corporation.  Debt of the corporation is a creditor interest.  Although the difference between an equity interest and a debt interest would appear clear, the difference between an equity interest and debt can often be very unclear.

Stock, Debt, Options & Hybrid Securities

Common Stock: Every corporation has at least one class of common stock outstanding.  The common stock holders are entitled to the corporation’s profit, increase in value and the right to vote on corporate matters.  Common stock however, would be considered more of a “junior” security due to because common stock holders are entitled to their rights only when required allocations have been made to other “senior” security holders.

Preferred Stock: A corporation can issue one or more classes of stock, and often a corporation will issue “senior” securities known as preferred stock.  A preferred stock holder’s right to current income and/or accumulated capital is limited.  Each share of preferred stock usually holds a stated liquidation preference, which is the amount to be paid on the retirement of the preferred stock and the amount paid to the corporation to acquire the preferred stock.  The limitation on current income of a preferred stock holder is usually limited to a percentage rate of the liquidation preference.  Thus, preferred stock can appear to be quite similar to a loan.  Generally, for tax purposes, preferred stock has been treated as “stock” and similar to common stock.

Debt: The debt of a corporation may come in many forms.  Extensions of credit (debt) could be a short term loan needed to purchase goods and inventory, or could be a long term investment in the corporation.  Further, a bank may loan money to the corporation.  Each form or type of debt is likely to have different terms and maybe secured by different means, or even unsecured.  In most circumstances and absent an agreement to the contrary, debt is senior to all stock.  Thus, interest on the debt is paid before dividends are paid to shareholders, and upon dissolution of the corporation, the debt is priority and will be satisfied first and foremost.

Options: An option is the right to purchase stock of the corporation, at a fixed price in the future.  Thus, the investor may be able to benefit in the later appreciation of the stock for a smaller current investment.

Hybrid Securities:  A single security may hold the attributes of multiple types of securities.  For example, a convertible security is a hybrid.  The terms of a debt instrument may allow the holder (creditor) to exchange the note or instrument for a specific number of shares of stock.  These forms of securities create difficulties in defining and labeling the security as either equity or debt.

Investing in a Corporation

An investor is free to make multiple types of investments in a corporation, and some investors prefer this balance and strategy.  The pertinent question for the investor is how to balance the additional security of debt against the stock’s potential for appreciation.

Debt or Equity Financing, or both?

Structuring the correct balance between debt and equity financing is not easy, and often, only time allows the investor or corporation to reflect upon the decisions made- hindsight is always 20/20!  However, the structuring can be vital to the success of the corporation and thus an investor’s rate of return on their investment.  There are tax and non-tax issues to consider, and often the answers to these issues create more questions and are in conflict with one another.  Some favor debt due to the fact that a C Corporations profits distributed on stock are subject to double taxation and the payment of interest on debt is deductible.  Investors may prefer debt due to the greater security and generally steady and consistent annual return on investment that is not always found with dividend payments.  Some favor stock because stock, unlike debt can be received in a tax free transaction.  Further, too much debt can impact the corporation’s credit, and the payment of debt interest can create cash flow issues for businesses, especially newer businesses.

We recommend that the business owners contact their business attorney or tax attorney when considering the formation and structure of their business.

Contact The McGuire Law Firm to schedule a free consultation with a Denver business attorney.