Question

Problem 13-40 (LO. 4) Parrott, Inc., a C corporation, is owned by Alfonso (60%) and Deanna (40%). Alfonso is the president, and Deanna is the vice president for sales. All three are cash basis taxpayers. Parrott encounters working capital difficulties, so Alfonso loans the corporation $810,000, and Deanna loans the corporation $540,000. Each loan is supported by a 5% note that is due in five years, with interest payable annually. Determine the tax consequences to Parrott, Alfonso, and Deanna if the notes are classified as (a) debt and (b) equity.

Answer 1

a) If the loans are classified as loans, the corporation can deduct interest expenses which ultimately helps to lower income taxes (and it is always better to pay less taxes).

b) If the money is classified as paid in capital instead of debt, then the corporation cannot deduct interest expenses. These loans will be treated similar to preferred stocks, whose preferred dividends do not affect net income.