The term “debt” often has a negative connotation and leaves business owners feeling worried and stressed out. However, debt is not always a bad thing. For closely held C corporations, debt can be a superior financing option when it comes to potential tax benefits. The tax advantages to debt financing can be applied to a newly acquired business or to an existing C corporation that needs more capital. The advantages can also apply to third party debt and/or owner debt.
Tax rate considerations
The tax advantages of a C corporation using debt over equity financing, like most things, comes down to the tax rates. There are four important tax rates to know to make an informed financing decision:
- 21% – The flat federal income tax rate paid by C corporations.
- 37% – The top individual federal income tax rate.
- 20% – The top individual federal tax rate on net long-term capital gains and qualified dividends.
- 8% – The net investment income tax rate paid by high-income individuals on their investment income (i.e. interest, dividends and capital gains).
The primary goal when tax planning for a C corporation is to avoid double taxation. Double taxation occurs when business profits are taxed at both the corporate level (rate 1) and then again at the individual level when dividends are paid out (potentially rates 2, 3 and 4).
Third-party debt
The use of third party debt in the corporation’s capital structure reduces the likelihood that shareholders will need to recoup their initial investment through taxable dividends. This risk of double taxation makes a shareholder funding the business entirely though equity inadvisable, even if they have the cash to do so. Instead, the shareholder contributes a smaller amount of capital upfront, still owns 100% of the business and simply uses the business cash flows to service the debt rather than pay back the shareholder. This helps the shareholder protect their personal cash and avoid additional tax at the individual level that would have been required if capital was returned through a dividend.
Owner debt
The use of owner debt looks to solve the same double taxation issue, but rather than using third party debt, the owner makes a loan to the corporation. This allows the shareholder the ability to finance the company with their own funds, like with equity. The main difference is the shareholder has a built-in mechanism for withdrawing their initial investment tax free. The mechanism is the tax-free repayment of the loan principal. Of course, you must include the interest payments in your taxable income. But the corporation will get an offsetting interest expense deduction — unless an interest expense limitation rule applies, which is unlikely for a small to medium-sized company. Ultimately, this will provide for a lower tax burden at the individual level compared to financing entirely through equity.
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. This exemption will protect most closely held small to medium-sized C corporations.
An illustrative example
Let’s say you plan to use your solely owned C corporation to buy the assets of an existing business. You plan to fund the entire $5 million cost with your own money — in a $2 million contribution to the corporation’s capital (a stock investment), plus a $3 million loan to the corporation.
This capital structure allows you to recover $3 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.
Ultimately, the use of debt in a closely held C corporation can reduce the tax burden on the shareholder by reducing the amount of taxable dividends that are required to pay back the initial equity investment. This allows the shareholder to avoid double taxation and preserve the return of their investment.
If you have questions regarding the use of corporate debt or how it may apply to your tax strategy, please reach out to a member of the Wegner CPAs tax team.
