Question

Sara is the sole owner of Yellow Corporation. Her basis in Yellow is $50,000. The value of her stock is $100,000. In addition, to compensate herself for services that she provides to Yellow, Sara pays herself an annual salary of $40,000. Because of recent downturn in business, she needs to put an additional $80,000 into her corporation to help meet short-term cash-flow needs (to pay for inventory costs, salaries, and administrative expenses). Should she do a capital contribution transfer of $80,000 or a loan? What is best for tax purposes? Explain your answer.

Answer 1

She should go for loan because :

1. Paying interest on debt reduces tax burden:

Many entrepreneurs aren’t aware of this surprise benefit of borrowing. The cost of interest reduces your taxable profit and, therefore, reduces your tax expense. The effective interest you’re paying is lower than the nominal interest because of this.

It is this lower cost of capital that should be factored in when calculating the return from taking on debt. Leveraged buyout firms have used this strategy for ages to rake in the dough. Small businesses, too, can use it to improve their company’s finances.

This further sets borrowing apart from selling equity as a means of financing your business growth. If you get cash from equity, you’re paying off that equity holder with cash from your business with no benefits to you, whereas debt gives you the benefit of lower taxes.

2. Tax Deductible Expenses
These are necessary and ordinary expenses that are beneficial for businesses to generate income. The deductible expenditures may be subtracted from the revenues before arriving at the tax liability. In other words, these expenses may be reduced from the gross revenue to lower the taxable income. The interest paid on the loan availed for the business is deductible, which helps lower the taxes for the company. Knowing the interest rates, processing fees and other terms and conditions before availing the loan are important.