Stock vs. Debt
When forming a corporation, a transferor-shareholder should take into account some necessary factors to determine whether or not receiving some debt along with stock.
1. Tax Factors [ ① ]. For the shareholder
Firstly, to meet the requirement of section 351, the shareholder transferor must receive only stock. Although the gain under section 351 is deferred, if some debts are received along with stock, the debt will be treated as boot and gain will be recognized.
Secondly, for debt financing, the principle return is tax-free and the interest of the debt is taxed at an ordinary rate. However, for equity financing, the dividends are taxed at a preferential rate although they are double taxed (at entity level and individual level). In addition, a corporate shareholder has benefit from DRD.
Thirdly, when debts become worthless or result in losses on the sale, it does not qualify under section 1244. In that case, shareholders generally have capital loss rather than the ordinary loss for section 1244 stock. The capital loss generally can be offset only by capital gain while ordinary losses are deductible against ordinary income. [ ② ].For the corporation
Firstly, when issuing sock or debt, if we do not consider the benefit of shareholders, there are not significant differences for the corporation because issuing both stock and debt is not taxable. Moreover, additional money or properties received from shareholders through voluntary pro rata transfers are also tax-free even without issuing stock. Secondly, the big different tax treatments for the corporation exist after issuing stock or debt. The repayments of debt’s principle are tax-free and the interest of the debt is deductible by the corporation while the corporation should be taxed on its profit before it distributes dividends.
Thirdly, the thin capitalization problems give the IRS opportunity to