Discussion:Thin capitalization of s corp
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Discussion Forum Index --> Tax Questions --> Thin capitalization of s corp
TaxAssistCPA (talk|edits) said: | 21 May 2006 |
| I have an S corp client (initial year 2005) and the owner has put in about $300,000 of his own money. There is about $150,000 in cash and $150,000 in inventory - fixed assets are mostly depreciated. I have polled several CPA friends and they say to classify it all as 'Shareholder Loan' except for the stock amount. This is a retail store. One CPA said that they would only put a large amount to 'Paid in Capital' if it were a heavy manufacturing business. What are your thoughts on the breakdown between PIC and loan? | |
Chautauqua (talk|edits) said: | 21 May 2006 |
| I believe the maximum acceptable is about 10 parts loan to 1 part capital. In your case, then, it would be $28,000 capital and $272,000 in shareholder loans. | |
| 21 May 2006 | |
| I don't think there's any prescribed ratio of loans to PIC. If you have a stockholder loan, you've to impute interest. Also, if the corporation is profitable, you can repay the loans. You can't repay PIC.
If a corporation has external debt (from banks or other financial institutions), my formula is to maintain a maximum debt-equity ratio of 2:1. This enables the corporation to maintain its loan covenants. | |
| 21 May 2006 | |
| I have not seen many thin capitalizations since securities became boot under sec 351 after 1989. Just curious, is there no appreciated property, or will there be recognized gain on appreciated property contributed? Sounds like the only a minimal amount of fixed assets are involved. | |
TaxAssistCPA (talk|edits) said: | 22 May 2006 |
| WillyB, I guess for discussion purposes, I was over-simplifying the situation. There are fixed assets with a book value of about $130,000 - and some liabilities to finish off the balance sheet. When a sole prop incorporates I usually just carry over the book value as contribution to the corp. I guess I'm simplifying again - but I know a lot of CPAs who do the same thing. What would you do? How do I recognize the gain on appreciated property? Thanks. | |
| 22 May 2006 | |
| Like Willy says,the world has changed. My practice is simple now, whatever money comes in initially is capital stock. Period. I think 351 actually requires that, no debt allowed initially. Whatever comes in after that intial capitalization is loan. | |
| 22 May 2006 | |
| Thin-Capitalization Rules
The U.S. tax law still favors characterization of shareholder contributions as debt rather than equity because interest expense is generally deductible against taxable income, and principal repayments can be used to distribute after-tax earnings with no further U.S. tax cost. No specific statutory limits are placed on the ratio of debt to equity, however a debt to equity ratio of 3:1 or less is generally acceptable assuming the taxpayer can service this debt on their own without assistance. Swiss American Chamber of Commerce Specific regulation is often found at the State level. | |
| 22 May 2006 | |
| JR1 is correct.
Forgive me if I (re) state what may be obvious to many or most: If appreciated property is transfered to a corporation in exchange for stock or debt, the assumption is that the debt or stock is worth the FMV of the property contributed and that the tranferor has gain to the extent of fmv - basis: Sec 1001. If the transferor meets the requirements of sec 351 and receives stock in exchange, the gain is not recognized. This applys not only to initial capitalizations, but downstream capitalizations. If cash or property with no appreciation is transfer, then debt or other boot could be issued by the corporation without gain (no gain to recognize). So yes, the US tax law still favors debt as capitalization, but if you are incorporating or doing a later transfer of appreciated property, there will be a boot (taxable) portion of the 351 transaction. | |
