TO: Mr. Jones, Client
FROM: Tax Professional
DATE: June 12, 2011
SUBJECT: Tax Advice
Several organization options were presented. Each option is presented below with the most optimal course of action, from a tax perspective. Each option has various tax benefits and drawbacks. The options will be evaluated independently. The option of outright purchase of Smithon will be evaluated first, followed by the options of merging or acquiring Smithon.
1a.) Should Mr. Jones purchase the stock of Smith outright, leaving Smithon intact? What about issuing debt in his Johnson Services company to pay for the Smith company – would that raise debt to equity issues?
Purchasing the stock of Smithon outright, leaving it intact, would qualify as a Type B reorganization. Johnson Services would transfer some of their voting stock to the Smithon shareholders. Johnson Services would be required to have at least 80 percent of the total combined voting power and 80 percent of each class of nonvoting stock. (Rev. Rul. 59-259, 1959-2 CB 115).
As to Mr. Jones’ question about issuing debt, there are advantages to issuing debt to raise funds. The interest payments are deductible to the corporation. However, the IRS may reclassify debt instruments as equity, using the doctrine of substance over form. There are five factors that may be considered when evaluating debt or equity classifications: 1) Does the instrument contain an unconditional promise to pay on demand or on a specified date a definite amount for adequate consideration and at a fixed rate of interest? 2) Is the debt preferred over or subordinated to other debts? 3) How high is the corporation’s debt to equity ratio? 4) Is the debt convertible to stock? 5) What is the relationship between stock and debt ownership? (Code Sec. 385). Of these considerations, the only one that is of concern is the debt to equity