Question

Frank, Cora and Mitch are equal shareholders in Purple Corporation. The corporation’s assets have a tax basis of 50,000 and a fair market value of 600,000. In the current year, Frank and Cora each loan Purple Corporation 150,000. The notes to Frank and Cora bear interest of 8% per annum. Mitch leases equipment to Purple Corporation for an annual rental of 12,000. Discuss whether the shareholder loans from Frank and Cora might be reclassified as equity. Consider in your discussion whether Purple Corporation has an acceptable debt equity ratio.

Answer 1

The shareholders of Purple Corporation have avoided pro rata holding of debt by having Mitch lease property to the corporation and receiving an annual rent that approximates the yield on the loans from Frank and Cora.
Because the loans are not pro rata, the IRS may have difficulty in reclassifying the debt as equity.
In addition, Purple Corporation can defend its debt-to-equity ratio by stressing the fair market value of its assets. If the tax basis of Purple Corporation’s assets is used, the ratio is 6 to 1 [$300,000 (liabilities) to $50,000 (tax basis of assets)]. However, if fair market value of its assets is used, the ratio is only 0.5 to 1 [$300,000 (liabilities) to $600,000 (value of assets)]. Thus, Purple appears to have an acceptable debt-to-equity ratio