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.