Chapter 3

Question 1

The 5 elements of capital structure:

Answer 1

1. Common stock (every corporation must have at least one class of common stock)
2. Preferred stock
3. Debt
4. Stock options
5. Hybrid securities

Question 2

16 Factors from the Fin Hay Realty Case

(and the 9 highlighted ones)

Answer 2

1. The intent of the parties
2. The identity between creditors and shareholders
3. The extent of participation in management by the holder of the instrument
4. The ability of the corporation to obtain funds from outside sources
5. The “thinness” of the capital structure in relation to the debt
6. The risk involved
7. The formal indicia of the arrangement
8. The relative position of the obligee as to other creditors regarding the payment of interest and principal
9. The voting power of the holder of the instrument
10. The provision of a fixed rate of interest
11. A contingency on the obligation to repay
12. The source of the interest payments
13. The presence or absence of a fixed maturity date
14. A provision for redemption by the corporation
15. A provision for redemption at the option of the holder, and
16. The timing of the advance with reference to the organization of the corporation

Question 3

Two types of compensatory stock options:

Answer 3

Non-qualified and

ISOs

Question 4

Taxable impact on grant and exercise dates of non-qualified and ISO stock options

Answer 4

Non Qualified:

1. No impact on grant date
2. Taxable on exercise date
3. Capital gain when stock is sold

ISOs

1. No impact on grant date
2. No impact on exercise date*
3. Capital gain when stock is sold

*Subject to AMT on difference between FMV of stock and strike price

Question 5

Definition of hybrid instruments and IRS Notice 94-47

Answer 5

Instruments treated as debt for tax purposes and equity for regulatory, rating agency and GAAP purposes

IRS Notice 94-47
Purpose of Notice:

1. IRS will scrutinize hybrid instruments to determine if their purported status as debt is appropriate
2. Of particular interest are instruments treated as debt but with a variety of equity features:
   
   1. Unreasonably long maturity
   2. An ability to repay the instrument’s principal with the issuer’s stock
   3. In addition, factors similar to those developed in the Fin Hay Realty case will be considered

Question 6

What section is ‘junk bond interest’ and what does it say?

Answer 6

§279 – Junk Bond Interest
Disallows annual interest in excess of $5,000,000 on “corporate acquisition indebtedness” if:

1. Proceeds are used to acquire another corporation or two-thirds of the assets of another trade or business,
2. Debt is subordinated to trade creditors and unsecured debt,
3. Debt is convertible into equity of the corporation, AND
4. The corporation’s debt to equity ratio is greater than 2:1 (on a tax basis) or the projected earnings do not exceed 3X the total annual interest to be paid or incurred

Question 7

What sections are the AHYDO sections and what do they say?

Answer 7

§§ 163(e) and 163(i) – Applicable High Yield Discount Obligation (AHYDO)

1. Disallows interest in excess of the AFR (applicable federal rate) + 6% if debt obligation:
   
   1. Maturity date is more than 5 years in the future,
   2. Yield to maturity is more than the AFR rate + 5% (based on the date of issuance), AND
   3. Has significant original issue discount (OID)

Question 8

What is the ‘earnings stripping’ section and what does it say?

Answer 8

§163(j) – Earnings Stripping

1. Interest expense in excess of 50% of adjusted taxable income is deferred if:
2. The corporation’s debt to equity ratio is greater than 1.5:1
3. The creditor is a related party, AND
4. The creditor does not pay U.S. tax on the interest income (generally a foreign entity)

Question 9

What section deals with PIK interest and what does it say?

Answer 9

§163(l) – Paid In Kind Interest (PIK interest)

1. Disallows interest on a “Disqualified Debt Instrument” if:
2. The debt will be paid off in equity (i.e., the debt will be converted to equity) OR
3. The debt instrument payoff will be calculated based on the corporation’s equity value

Question 10

Whats the difference between a business bad debt and a non-business bad debt?

Answer 10

Business bad debt gets an ordinary loss but non-business bad debt gets short-term capital loss treatment.

Question 11

What are the facts, issues, and holding of the Generes case?

Answer 11

Creditor’s Loss Treatment
United States v. Generes
Facts:

1. In 1954, Generes and his son-in-law Kelly formed a construction company (Kelly-Generes Construction Co., Inc.) to engage in heavy-construction projects
2. Generes owned 44% of the stock, was president of the corporation and received an annual salary of $12,000 (yes, this was the 1950s and early 1960s!!)
3. Generes loaned money to the corporation (from time-to-time), acted as guarantor on several corporate loans and indemnified the bonding company to a certain extent
4. In 1962, the corporation seriously underbid two projects.
5. Generes ultimately paid the bonding company $162,105 under the indemnity
6. Generes also loaned the corporation an additional $158,814 to keep it a float
7. The corporation went into receivership and Generes was unable to recover these monies
8. On his 1962 return, Generes claimed a nonbusiness bad debt loss for the $158k loan and claimed a business bad debt loss for the $162k paid to indemnify the bonding company
9. At trial, Generes testified that his sole motive in signing the indemnity agreement was to protect his $12,000/year salary!!

Issue:
As it relates to the ordinary loss claimed by Generes (related to his “business” bad debt), was the payment (indemnification) made of such a nature that it was “proximately related to his trade or business of being an employee”?

Holding:
The Supreme Court held that based on a “dominant” (as opposed to a “significant”) motivation standard, Generes is not entitled to an ordinary “business” loss deduction

Question 12

What section deals with the ‘cancellation of debt’, and what does it say?

Answer 12

Cancellation of debt (§108)

1. §108(a)(1) – Discharge (cancellation or forgiveness) of debt is generally included in the debtor’s gross income unless:
   
   1. The debtor is in bankruptcy
   2. The debtor is insolvent
   3. The debt is qualified farm indebtedness, or
   4. The debtor is NOT a C Corporation and the indebtedness discharged is qualified real property business indebtedness
2. §108(e)(8) – debt satisfied by the corporation issuing stock
   
   1. Debt satisfied to the extent of the FMV of the stock

Question 13

What are the facts, issues, and holding of the Plantation Patterns case?

Answer 13

Chapter 03-06
Shareholder Guarantees – Plantation Patterns, Inc. v. Commissioner
Facts:

1. John S. Jemison, Jr. and Jemison Investment Company, of which he was president and controlling shareholder, formed a new corporation, New Plantation, to purchase all of the stock of Old Plantation from unrelated individuals
2. All of the stock of New Plantation was issued to Mrs. Marie Jemison in exchange for $5,000.
3. Mr. Jemison was active in the business of New Plantation; Mrs. Jemison was not active
4. New Plantation obtained a loan from Bradford and Company in the amount of $150,000 in exchange for a 6-1/2% debenture subordinated to all other debt of New Plantation and not guaranteed
5. Bradford loaned the money to New Plantation to induce Jemison to hire his son at New Plantation!!
6. The stock of Old Plantation was acquired for $100,000 cash and 5-1/2% notes in the principal amount of $610k.
7. These notes were guaranteed by Jemison and Jemison Investment Company
8. With the exception of $100,000 of the notes, they were subordinated to all creditors of New Plantation excluding Bradford and Company
9. The IRS disallowed New Plantation’s interest expense associated with the 5-1/2% notes and claimed that Jemison and Jemison Investment Company had made an equity contribution to New Plantation and such equity contribution was used to acquire the stock of Old Plantation!!

Issues:
Whether the $100k of nonsubordinated notes should be treated debt
Whether the remaining portion of the debt ($510k) should be treated as debt where the notes were subordinated to all other New Plantation debt other than the Bradford loans

Holding:
The court held that the entire $610k of debt guaranteed by Jemison and his company should be treated as an equity contribution by the Jemisons

Question 14

What is the tax treatment for equity holders for dividends and the sale of stock?

Answer 14

Equity Holder’s Tax Treatment
Dividends

1. Individuals – 15% rate
2. Corporations – “dividend received deduction” (DRD)

Sale of Stock

1. Short-term capital gains
2. Individuals – 35%
3. Corporations – 35%
4. Long-term capital gains
5. Individuals – 15%
6. Corporations – 35%

Question 15

What are the two sections that deal with ‘Special Equity Benefits’ and what do they say?

Answer 15

1. §1202 – 50% of gain excluded if:
   
   1. Stock sold meets the definition of “qualified small business stock”
   2. Stock sold was held by non-corporate taxpayer
   3. Stock sold was held for more than five years
   4. Note that the sale is taxed at the old LTCG rate of 28% (or after exclusion 14%)
2. §1045 – Rollover of gain on sale of qualified small business stock if:
   
   1. Taxpayer is not a corporation
   2. Stock sold was held for at least 6 months
   3. Taxpayer elects to have §1045 apply
   4. Replacement stock acquired within 60 days of the sale
   5. Replacement stock qualifies as “qualified small business stock”

Question 16

What does 1044 deal with and what does it say?

Answer 16

1. §1044 – Rollover of gain on publicly traded securities into specialized small business investment companies
   
   1. Taxpayer elects to have §1044 apply
   2. Replacement property is acquired within 60 days of the sale
   3. Replacement stock is stock in a “specialized small business investment company” (under the Small Business Investment Act of 1958)

Question 17

What sections deal with ‘worthless stock’ and what do they say?

Answer 17

Capital loss (§165(g))

1. §1244 Stock – will convert up to $100,000 (on a joint return) of the §165(g) capital loss to an ordinary loss if:
2. Holder of stock is an individual
3. Stock when issued was stock in a small business corporation ($1 million of original capital)
4. Stock was issued for money or other property
5. Holder must be the original owner
6. 50% or greater of the corporation’s income over the past five years must be something other than portfolio (investment) income