MEMORANDUM
TO: Ms. Sara, Client
FROM: XVZ , Analyst
SUBJECT: Taxation Advice
DATE: October 12, 2014
Introduction
This memo evaluates the report evaluates the options that you have in investing $80,000 additional cash to expand Blue Grass Corporation, with a view to advising on the most secure option in the event that Blue Grass Corporation condition worsens to the extent of resulting into a bankruptcy. We explore the situations from the perspective of tax law, including the legal position and implications of various options that you may have.
1. Facts:
The present scenario relates to one Sara, who solely owns a corporation, Blue Grass Corporation, valued at $100,000. She is full employed in the corporation and now contemplates adding $80,000 to help run operational expenditure, following austerity. She contemplates three possible options to structure the transfer of the money from her personal account to the company’s account, namely: (1) channel it as a capital contribution to Blue Grass Corporation; (2) as a loan Blue Grass Corporation as a means of protecting her investment in stock; or (3) as a loan to protect her job.
2. Question Presented: Which of the three alternative solutions should Sara pursue as the most preferable option, from tax law perspective, in the event that Blue Grass Corporation is declared bankrupt?
3. Short Answer: Ms Sara should channel it as a capital contribution to Blue Grass Corporation, because contribution of capital does not give rise to a debt, as so in the event of bankruptcy the $80,000 will not be included in Blue Grass Corporation taxpayer’s gross income thus increasing tax liabilities. The alternative options will be considered debts and so be included as part of Blue Grass Corporation taxpayer’s gross income.
4. Analysis:
4.1 Issue:
The primary tax law issue in this case is:
Are the contemplated options amount to the creation of a debt, as to be classified as part of Blue Grass Corporation‘s gross income in case of the corporation’s discharge of indebtedness?
4.2. Rule:
Pursuant to Internal Revenue Code, 26 U.S. Code § 61, taxpayers may have a duty to bill their gross income for tax consequences in the event that their debts have been canceled , under a doctrine referred to as Cancellation of Debt (COD) Income. Section 61(a)(12)of the Internal Revenue Code specifically classifieds the discharge of indebtedness as part of a taxpayer’s gross income for purposes of computing one’s gross income in the event of insolvency . Compensation for services such as fees, commissions are also part of gross income. Taxpayers are bound to report such income in statutory forms, which will then be reviewed to and form part of differed tax obligations of the taxpayer.
4.2 Application:
The starting point for the discussions here is to acknowledge that Blue Grass Corporation and Ms Sara are two different legal entities (Berk et al., 2010). Blue Grass Corporation is a corporate person, capable of owning properties in its own name, and also bearing liabilities as well as being entitled to its rights just as a natural person, Ms Sara (Jean-Philippe, 2011). Thus, if she provides finance to Blue Grass Corporation, on an understanding that it is a loan to take care of any activity or operations of the company, then a reallocation of such cash (as an asset ) occurs , where the cash (asset ) remains Blue Grass Corporation’s for a specified duration of time. Blue Grass Corporation will be bound to pay back the principal (plus interest if that is the terms of loaning). Under these circumstances, should Blue Grass Corporation run into bankruptcy before the cash is paid back (reallocated) to Sara, then the Corporation will be discharged from indebtedness, and as such the debt will have to be treated as part of the Corporation’s gross income. Thus, in the circumstances where Sara decides to structure the additional funds as a loan to Blue Grass Corporation as a means of protecting her investment in stock; or as a loan to protect her job, it will remain to be a loan susceptible to discharge of indebtedness.
On the contrary, in the event that she structures the cash as a capital to the Corporation, then the capital will be considered to be part of the corporation’s assets (Admati et al., 2011; Edwards & Shevlin, 2011). Since there is no duty to pay back the capital, the money cannot be added to the gross income of the company as would have been done in case of discharge of indebtedness. That is, the issue discharge from indebtedness does not arise in the case of capital, as there is no debt in the first place. Upon an insolvency, the money will be considered to have been consumed by business operations.
Conclusion :
All forms of loans does not transfer ownership of the $80,000 from Ms Sara; it only vests the asset temporarily on Blue Grass Corporation and in case of insolvency and so the corporation will have to add it to its gross income for tax consequences. However, if the money is structured as a capital, the money will remain an asset of the corporation and thus no obligation to add it to as part of gross income for tax purposes in case of insolvency. Structuring the money as capital is, therefore, the best option.
References
Admati, A. R., DeMarzo, P. M., Hellwig, M. F., & Pfleiderer, P. C. (2011). Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not expensive. MPI Collective Goods Preprint, (2010/42).
Berk, J. B., Stanton, R., & Zechner, J. (2010). Human capital, bankruptcy, and capital structure. The Journal of Finance, 65(3), 891-926.
Edwards, A., & Shevlin, T. (2011). The value of a flow-through entity in an integrated corporate tax system. Journal of Financial Economics, 101(2), 473-491.
Internal Revenue Code, 26 U.S. Code § 61
Jean-Philippe, R. (2011). The legal structure of the firm. Accounting, Economics, and Law, 1(1), 1-88.
