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Advantage of Debt Financing

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THE ADVANTAGE OF DEBT FINANCING
Interest on debts paid by a corporation is deductible as an ordinary and necessary expense of the corporation .
The general rule governing the interest taxation can be found in 26 U.S. Code § 163 : “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.” In other words, if the payments are categorized as interest, they will be deducted from the taxable earnings and there will result the also-called “the tax benefit of debt”. A. Constructive dividends.
The only problem concerning this advantage is that in some cases IRS (Internal Revenue Service) can consider this just a scheme to avoid double taxation, and characterize these payments as “constructive dividends”. As a result, the deduction benefit is lost and the corporation must pay taxes on the amounts of money that are considered interest. “When a corporation confers an economic benefit upon a shareholder, in his capacity as such, without an expectation of reimbursement, that economic benefit becomes a constructive dividend, taxable to the respective shareholder. This benefit is taxable to the shareholder whether or not the corporation intended to confer a benefit upon him” .
The term “constructive dividends” is usually used to describe that situation when the corporations pays the stockholders-employees “salaries”, for the services they rendered to the business entity. This is just another method to avoid double taxation: the salaries are considered legitimate expenses of the corporation, so the income level of the entity, which will be subject to taxation, will be lowered. However, taking into consideration that the mechanisms to lower the taxation economic consequences have expended, we can say that “ constructive dividends” nowadays have a broad meaning, including “ any payment made by a corporation to a shareholder,

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