Introduction to the Components of Capital Structure

An Introduction to the Components of Capital Structure of Corporations

The capital structure, or how a business is financed, will always be through one or more of the following sources:

  1. Debt
  2. Equity, which is contributed capital
  3. Equity, which is retained earnings

These instruments, whether debt or equity, can be issued in exchange for cash, property, or services.

Debt from the investor side:

  • If an investor puts cash into a business and is issued debt such a bond or debenture, it’s just a loan. As that loan is paid back to the investor in payments, the payments will include interest and principal. The interest enriches the investor, so the interest amounts are taxed. The principal portion of the payments are just a return of capital to the investor, so those aren’t taxed.
  • If an investor transfers property into the corporation in exchange for debt, what you really have is an installment sale. As interest payments are made back to the investor, the payments are taxed as ordinary income to the investor, and principal payments are subject to tax to the extent of the gross profit ratio determined under the installment obligation.
  • If the investor puts in prior services in exchange for debt, that is taxable according to the fair market value of the services rendered.

Equity from the investor side:

  • If an investor puts in cash in exchange for equity, the investor recognizes no income. But, as distributions are made, there may be tax on dividends or redemptions- we’ll cover this later.
  • Property is the same way- no gain or loss recognized but dividends or redemptions may be taxable later on.
  • If in investor trades services for equity, this is governed by Section 83. The general rule is that the stock received in exchange for services is taxable as compensation in the amount equal to the fair market value of the services traded.
    • One exception to this rule is if the investor has an obligation to complete in order to have free and clear ownership of the stock, the receipt of stock isn’t taxable until that obligation is met and the stock is owned free and clear by the investor.
    • One exception to this exception is that if the investor receives stock but has a substantial risk of forfeiture- such as completing 3 years of employment before the stock is owned free and clear- the investor can elect to pay tax on the value of the stock on the day they receive the stock, instead of paying tax later and potentially paying more tax because the stock has gone up in value.

Debt from the corporation’s side:

  • In an investor contributes cash, property, or services for debt such as a bond or debenture, the corporation ends up getting an interest deduction as interest payments are made to the investor. This is a huge motivator for businesses to structure their capital with debt.

Equity from the corporation’s side:

  • Dividends paid out on equity to investors doesn’t provide the corporation with any deductions. Hence the motivation to structure more of the capital with debt than equity.

Basics of Capital Structure

  • Common stock: Every corporation must have at least one share of common stock. Common stock is the most risky form of investment, but it also has the potential of higher reward.
  • Preferred stock: Preferred stock generally does not share in the growth of the corporation like common stock does.
  • Debt is lower risk than stock, because you get paid back before the equity holders do. The return on debt is fixed however- there’s not potential for higher return.
  • Stock options
  • Hybrid securities

Debt vs. Equity Court Cases

Fin Hay Realty Co. vs. United States

  1. The intent of the parties
  2. The identity between creditors and shareholders: If the creditors are unrelated to the shareholders, that makes the transaction look more legitimate, and goes back to the intent of the parties. Problems arise when the creditors and the investors are the same parties, but that happens a lot.
  3. The extent of participation in management by the holder of the instrument
  4. The ability of the corporation to obtain funds from outside sources: In closely held corporations, you’ll usually see more debt than equity. This means that the corporation would have a hard time going to a bank and getting a loan on the same terms that the shareholders have loaned money to the corporation- which creates issues.
  5. The “thinness” of the capital structure in relation to the debt: This means that there’s little equity in relation to the amount of debt.
  6. The risk involved: Common stockholders should have a much greater risk than debt holders. If the debt holders have as much risk as the stockholders, that’s a problem.
  7. The formal indicia of the arrangement
  8. The relative position of the obligee as to other creditors regarding the payment of interest and principal: Is the debt subordinated to other creditors? Do other creditors hold a higher right of getting paid back than the shareholder-creditors?
  9. The voting power of the holder of the instrument
  10. The provision of ta fixed rate of interest
  11. A contingency on the obligation to repay
  12. The source of the interest payments
  13. The presence or absence of a fixed maturity date: If you have a note that goes on forever, that looks a lot more like equity than debt.
  14. A provision for redemption by the corporation: If there’s stock that has a redemption option by the corporation, that looks a lot more like debt.
  15. A provision for redemption at the option of the holder: This also seems more like debt.
  16. The timing of the advance with reference to the organization of the corporation

Stock Options Explanation

A stock option is the right to buy stock at a fixed dollar amount in the future regardless of what happens to the value of the stock. We’ll go over two types of stock options:

  • Compensatory and
  • Non-compensatory

Compensatory Stock Options Explanation

compensatory stock options explanation

This is when an employee of the company is given the right to purchase stock in the future at a set price as compensation.

There are two types of compensatory stock options:

  • Non-qualified
  • ISOs

compensatory stock options table

So, when a corporation gives non-qualified stock options to an employee, on the grant date nothing happens- there is no tax impact because the employee hasn’t received any income. But, the day that the employee exercises the option by purchasing stock at the option price, that is taxable. This creates ordinary income in the amount of the difference between the fair market value of the stock and the option price paid. The employee’s basis in the stock is the amount he or she paid for them, plus the income it generated… this means it’s equal to the fair market value of the stock on the date of exercise. Then if the stock goes up in price and the employee sells the stock, the gain will be taxed at capital gain rates but only on the difference between the stock’s value on the date of sale and the stock’s value on the exercise date.

For incentive stock options, or ISOs, there is also no impact on the grant date. There is also no tax impact on the exercise date, but there’s a small exception. The exception applies if the taxpayer is using the alternative minimum tax. When the employee sells the stock, that will be taxable on the difference between the stock’s value on the sale date and the price paid on the exercise date.

Non-Compensatory Stock Options

non compensatory stock options

This means stock options that aren’t being used as compensation to employees.

  • There are two types of these options:
    • Puts: this option forces the seller to buy the stock at a certain price. These are used if the investor thinks the stock price will go down.
    • Calls: a call is the right to buy stock at a certain price. The call holder is gambling that the price of the stock will go up.
    • For each of these two types of options there is a:
      • Buyer: the one who holds the option
      • Seller: the seller is waiting for the purchase to take place

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