Tax Law Favors Corporate Debt over Equity
If you decide to use a C corporation to operate your newly acquired business, you should know that our current federal income tax system treats corporate debt more favorably than corporate equity. So including some third-party debt (owed to outside lenders) and/or some owner debt (owed to yourself) in your corporation’s capital structure is a tax-smart move.
Even if you could afford to cover the entire cost of the new business with your own money, tax considerations may make this inadvisable. That’s because a C corporation shareholder generally cannot withdraw part of his or her equity investment without worrying about the dreaded double taxation issue. If the corporation has current or accumulated earnings and profits, all or part of the withdrawal will be treated as a taxable dividend. You want to avoid dividends if you can.
Taxable dividend treatment means taxable income for you without any offsetting deduction for your corporation—that is, after your corporation has already been taxed on its profits. This is double taxation in all its glory.
When third-party debt is used in your corporation’s capital structure, it becomes less likely that you will need to be paid taxable dividends. The corporation’s cash flow can be used to pay off the debt, and when the debt is paid off, you will own 100 percent of the corporation with a smaller investment on your part.