Question

Imagine that you are a certified Public Accountant (CPA) with a new client who needs an opinion on the most advantageous capital structure of a corporation. Your client formed the corporation in question to provide technology to the medical profession to facilitate compliance with the Health Insurance Portability and Accountability Act (HIPAA). Your client is very excited because of the ability to secure several significant contracts with sufficient capital. Rearch the advantages and disadvantages of debt for capital formation versus equity for capital formation of a corporation. As a tax advisor for the client you are to write a one or two page letter in which you compare the tax advantages of debt versus equity capital formation of the corporation to include the following: 1) You should determine the fact based on your tax research. 2) You must identify the issues (questions). 3) You should locate the applicable authorities in tax regulations. 4) You should evaluate the authorities and choose those to follow where the authorities conflict in tax laws or regulations. 5) You should analyze the facts in terms of the applicable authorities, and 6) You should communicate conclusions and recommendations to the client based on your tax research.

Answer 1

Hint to the above question

Taxpayers investing in debt deals are typically not partners to an operating trade or business and are merely acting as just investors. They do not get to participate in any financial upside of the property. Accordingly, the payments they receive are typically classified as interest income. They will often receive a 1099-INT at the end of the year that reflects the interest income they received, but also may receive a Form K-1 depending on the deal structure. Interest income is considered portfolio income (not passive income) and is also subject to marginal tax rates. However, portfolio income is not considered passive income and is not subject to the same restrictions.Since equity investors are actually partners to the deal they would receive a Form K-1 at the end of the tax year which would report their share of the partnership’s income or loss. Since they are not actively involved in the day to day management of the property, they are typically classified as “passive” partners. Passive partners have special tax rules. A passive partner is taxed at the partner’s marginal tax rate on any profit that is generated. However, if the activity generates a lossthe deduction typically will be limited to any income derived from other passive activities (subject to certain exceptions). But if the activity generates income it may also be used to offset any passive losses generated from other activities.The tax code tilts in favor of debt compared with equity because it handicaps equity with the second layer of tax, not because debt receives preferential treatment. Therefore, it does not make sense to equalize their tax treatment by eliminating interest deductibility for businesses. Doing so would further suppress economic growth, job creation, and wage increases.