@117 CHAP 8 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � THINLY CAPITALIZED CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� TAX ASPECTS. Tax advisers often counsel their corporate clients to set up their corporations with as much debt cap- ital as possible, rather than having all of their ownership in the form of stock. This can have two significant tax advantages: . The interest paid on the debt holders will usually be deductible to the corporation for income tax purposes, unlike the dividends paid on its stock. . If properly set up, repayments of the princi- pal amount of debt instruments will be a tax- free withdrawal of funds from the corporation, whereas payment of dividends or redemption of its stock by the corporation would usually result in taxable income (capital gain or ordinary) to the shareholder receiving the payment. This is usually good tax advice, if the strategy is not tak- en too far. However, C corporations that have virtually all of their capital in the form of debt, rather than equi- ty (stock), may be challenged when they try to deduct the interest on the debt, particularly if the debt is held by stockholders, more or less in the same proportion as their stockholdings. The IRS will argue that such debt is more like "equity" capital, and, therefore, that the interest paid on it, and often the principal payments as well, are actually dividends. (Such a corporation is often called a "thin" corporation, or is said to be "thinly capitalized.") This can be a "double whammy" if the IRS can make its case stick. Not only is the interest expense disallowed as a deduction to the corporation, but the principal repayments are tax- able, wholly or in part, to the shareholder-lenders. Since it is highly tempting, for tax reasons, to structure a new corporation with as much debt as possible, a company can easily get into the "thin corporation" predicament when taxpayers get greedy. While there is no absolute dividing line between a corpora- tion that is too thinly capitalized and one that is not, most courts and tax advisers would tend to agree that where debt is more than 3 times equity, a corporation is probably walking on thin ice for tax purposes in this regard. S corporations and unincorporated enterprises do not share this problem. The IRS tried for years to treat such "thin" debt as a second class of stock in order to disqualify S corporations (which can only have one class of stock), but Congress pulled the IRS's plug on this issue, at least in the case of certain "straight debt" (debt that has a fixed interest rate and is not convertible into stock, generally.) For sole proprietorships and partnerships, thin capitaliza- tion is not a tax issue. They may have as much debt and as little equity capital as they wish, and don't have to just- ify their capital structure to the the IRS (only to their bankers). @IF119xx]Thus, because your company is not currently a C corporation, @IF119xx]the tax problems of thin corporations are unlikely to apply @IF119xx]to you, except in the event of a change of legal entity to C @IF119xx]corporation status by @NAME. @IF119xx] CORPORATE LAW PROBLEMS OF THIN CAPITALIZATION. The main reason most businesses incorporate is to limit the personal liability of the owners for the debts, taxes and other lia- bilities of the business to the amount they have invested in it. Generally, stockholders in a corporation are not personally liable for claims against the corporation, and are, therefore, at risk only to the extent of their invest- ment in the corporation. Likewise, the officers and direc- tors of a corporation are not normally liable for the cor- poration's debts either, although in some cases an officer whose duty it is to withhold federal income tax from em- ployees' wages may be liable to the IRS if the taxes are not withheld and paid over to the IRS as required. However, the advantage of limited liability is not always completely available through incorporation. For example, one must beware of starting a corporation "on a shoe- string." If a corporation is capitalized too thinly with equity capital (owner's money) as compared with debt capi- tal (borrowed money), the courts may determine that it is a "thin corporation" for corporate law purposes and hold the shareholders directly liable to creditors. Also, fail- ure to observe corporate formalities (commingling corporate and personal funds, not holding board meetings to approve corporate actions, not maintaining minute books, etc.) can have a similar drastic result. When this happens, it is called "piercing the corporate veil" by the courts. @IF127xx]Typically, corporations tend to get into this type of trouble @IF127xx]most often when the stock is owned by a single person, such @IF127xx]as in the case of @NAME. @IF127xx] What this term means is that if a corporation is not ade- quately capitalized and properly operated to protect the interests of creditors, the courts will take away the "veil" of limited liability that normally protects the corporation's shareholders. Piercing the corporate veil is relatively uncommon. A much more frequent problem is that many banks and other lenders will not loan money to a small incorporated business unless someone, usually the stockholders of the corporation, per- sonally guarantees repayment of the loan. Despite this common business practice, the feature of limited liability can still be an important protection from personal liabili- ty for other debts, such as accounts payable to suppliers and others who sell goods or services to the corporation on credit, typically without requiring any personal guarantee of payment by the owners. Even this partial protection is a significant advantage of incorporating most small busines- ses. In addition, being incorporated can also protect you in many cases from personal liability from lawsuit damages not covered by your corporation's liability insurance poli- cies if, for example, someone slips on a banana peel in your store and sues the corporation for $10 million. While the corporation might be bankrupted in such a case, your personal assets would not ordinarily be taken away by the corporation's creditors, if the corporate veil is not pierced. 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 쿍OTTOM LINE ADVICE: If you do business in corporate� 쿯orm, (1) Be sure the corporation is not too thinly� 쿬apitalized; (2) Be careful to observe all necess-� 쿪ry corporate formalities such as annual meetings of� 퀂hareholders, board of directors meetings, keeping� 쿪dequate minute books and other corporate records.� �(Take particular care not to intermingle your assets� 퀇ith corporate assets, such as bank accounts.) � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸