If you intend to use a C corporation for a newly acquired business or need additional capital for an existing C corporation, it's important to be aware that the federal tax code favors corporate debt over corporate equity. So, considering your shareholders, it’s smart to include in the corporation’s capital structure some third-party debt (owed to outside lenders), and/or some owner debt.
Let’s review some basics.
The top individual federal income tax rate is currently 37%
The top individual federal rate on net long-term capital gains and qualified dividends is currently 20%
Higher-income individuals may also owe the 3.8% net investment income tax on all or part of their investment income, which includes capital gains, dividends and interest
The Tax Cuts and Jobs Act (TCJA) established a flat 21% federal income tax rate on taxable income recognized by C corporations
Using Third-Party Debt
Using third-party debt financing to buy a C corporation or add more capital means shareholders don't have to put in as much of their own money. Even if they can afford to do so, it's often better not to because of tax issues. When shareholders take money out of their equity investment, they usually face double taxation: the corporation pays taxes on its profits, and then shareholders pay taxes again when they receive dividends.
When third-party debt is included in a corporation's capital structure, shareholders are less likely to receive taxable dividends because they have less of their own money invested in the business. Instead, the corporate cash flow can be used to pay off the debt. Once the debt is paid off, shareholders will own 100% of the corporation with a smaller initial investment.
Using Owner Debt
If all your investment in a successful C corporation is equity, you could face double taxation when you try to withdraw some of it. But if you also include owner debt (money you loan to the corporation), you can withdraw that part of your investment tax-free, since loan repayments are not taxed. You will have to pay tax on the interest payments, but the corporation can usually deduct the interest as an expense. This rule generally applies to small to medium-sized companies.
An unfavorable TCJA change imposed a limit on interest deductions for affected businesses. However, for 2024, a corporation with average annual gross receipts of $30 million or less for the three previous tax years is exempt from the limit.
Here’s an Example.
Let’s say you plan to use your C corporation owned only by you to buy the assets of an existing business. You plan to fund the entire $7 million cost with your own money — in a $3 million contribution to the corporation’s capital (a stock investment), plus a $4 million loan to the corporation.
This capital structure allows you to recover $4 million of your investment as tax-free repayments of corporate debt principal. The interest payments allow you to receive additional cash from the corporation. The interest is taxable to you but can be deducted by the corporation, as long as the limitation explained earlier doesn’t apply.
We hope to have explained the tax advantages to including debt in the capital structure of your C-Corp. If you’re interested in learning more, contact us for help.