papers in a basket“Cash is king” has been the motto du jour for businesses across the nation. The coronavirus pandemic hit our economy hard, and businesses that overcame the initial financial setbacks did so by having quick access to cash. Some applied for cash grants, others strengthened their cash flow practices, and some explored new ways to make money. But these methods have not worked for all. Some businesses need a bit more help.

Debt Financing

To finance business operations using debt, companies can either (1) take out a loan, or (2) issue bonds directly to investors.

Taking out a loan may have been a simple process before, but the economic downturn has changed the lending landscape — at least for now. As defaults on existing loans and demand for new loans have both skyrocketed, most commercial lenders are hesitant to issue credit indiscriminately. Many lenders are still accepting new credit applicants, but the approval process will likely be more involved than it has in the past.

Issuing debt is different from borrowing in one key respect: Rather than accepting money from a bank, the company accepts money from public investors. In exchange for cash, the company provides investors with a bond that is a promise to repay the principal at a future date, plus interest. Bonds are not bound by the same rules that commercial loans often are, so interest rates and terms can be better tailored to the relationships and risks at play.

Equity Financing

Equity financing requires a business to sell a portion of the company’s equity (i.e., ownership) in exchange for capital — often cash, but it can be other assets like real or tangible property, marketable securities, or intangibles. This investment does not need to be repaid, but the business must share future revenues with the equity investors. Equity financing requires existing business owners to give up a percentage of their ownership. This dilutes control for the original owners and could mean giving up decision-making authority.

Tax Consequences

Debt financing is treated favorably under U.S. tax law. Businesses can deduct the interest payments they make on their loans or bonds, which lowers the overall cost of financing. Businesses can sometimes even take interest deductions when they haven’t made any interest payments. Tax law states that loans at below-market rates are subject to “imputed interest,” which is the interest that the IRS assumes has been paid and is subject to taxation whether the borrower paid it or not.

Imputed interest is not uncommon. Some businesses issue bonds that stipulate that they pay interest to the bond holders in one lump sum at the end of the bond’s term rather than over the life of the loan. Other bonds (like zero-coupon bonds) are issued at below-market interest rates. In both cases, bond holders must recognize interest income at market rates, and businesses can take corresponding interest deductions.

The costs of equity financing are less favorable from a tax perspective. Dividend payments and return of capital are not deductible to the business. In fact, equity financing costs in C corporations get taxed twice: once on the corporation’s business return, then once when those dividends are distributed to the investors. This more favorable tax treatment of debt encourages businesses to be highly leveraged and discourages them from pursuing equity as a method to finance their operations.

Mistakes to Avoid

If businesses classify a financing activity as debt when it’s truly an equity infusion, they are at risk that the tax courts will reclassify their debt. This will require them to repay taxes on those lost deductions and pay the associated interest and penalties. S corporations are also at risk of losing their S election if the courts can prove they have more than one class of stock.

When determining whether the financing is considered debt or equity, the IRS and the tax courts will look at some of the following factors:

  • Whether there is a promise to repay the investment
  • Whether there is a fixed maturity date
  • Whether the debt is treated as subordinate to other debt on the company’s books
  • Whether the capital infusion is permitted to be converted into stock
  • What the debt-to-equity ratio of the company is at the time of the infusion
  • Whether interest payments are dependent on the business’s future performance
  • How the infusion of capital is used — for operations or for capital investment

None of these factors alone will determine debt or equity classification; the courts will look at the picture as a whole before deciding.

Questions?

The economy is improving, but slowly, and business leaders should review the financing options they have available. If you have questions about how best to finance your business operations, from both a tax and an operational perspective, contact our CRI CPAs today.