Capital Requirements for Bluegill Corporation - Essay Example

An individual who had opted to operate a business as a sole owner and organized the business as a C Corporation can elect to have the corporation taxed as if it was a partnership under Subchapter S of the Internal Revenue Code (Parker & Yash, 2007, p. 29) or the Code, otherwise the business is taxed under the Subchapter C of the Code. Moreover, during the liquidation process, the liability of a sole owner of an S or C corporation is determined by the amount of money the owner has invested in the business, hence personal assets are not subject to the rights of creditors to seize or place a lien.

            Furthermore, when an entity undergoes bankruptcy proceedings and files for Chapter 11, the assets of the corporation are transferred to the bankruptcy estate, however “a transfer (other than by sale or exchange) of an asset from the debtor to the estate shall not be treated as a disposition for purposes of any provision assigning tax consequences to a disposition and the estate shall be treated as the debtor would be treated concerning such asset” (IRC section 1398(f)).

            Given the above tax laws, rulings, and regulations, if Susan treats her additional $80,000 as an additional stock investment, which will then increase the value of her total stock to $180,000, for tax purposes, she will not be able to report the loss of the additional stock investment or the total value of her stock as a loss in her tax return. Section 1398(f) of the Code specifies that the bankruptcy estate will accrue the losses – both from operations and other items – of the business of the year that the bankruptcy process commenced. Hence, given the treatment of the $80,000 additional investment as a stock investment, on the year that Bluegill files for bankruptcy this amount and the rest of Susan’s equity investment in the corporation will become the losses of the estate rather than her losses.

            However, the tax implications would be different if the $80,000 additional tax investment is treated by Susan as a loan to Bluegill Corporation. In this circumstance, Susan, to the extent of the $80,000 loan, is considered a debtor. Hence, the tax treatment is different. However, the remaining stock value of Susan of $100,000 will still be treated the same way as identified above. For the $80,000 loan, during the bankruptcy proceedings, Susan can then assume a creditor’s right to seize or attach a lien on the corporation’s assets. Any loss resulting from the bankruptcy of Bluegill concerning the $80,000 loan can be reported in Susan’s individual income tax return.

            There is a way for Susan, however, to claim the losses from her total stock investment in her tax return in case Bluegill files for bankruptcy. To be able to do this, Susan needs to file the bankruptcy right after the end of Bluegill’s fiscal year. Corporation’s fiscal year ends every December 31. Hence, Susan needs to file for bankruptcy right after this time.

            Whether the additional $80,000 investment can be considered a bona fide loan or a capital contribution or both, several factors need to be considered. First, whether the business was undercapitalized during the additional contribution. If capitalization was sufficient, then the additional investment can be considered as a bona fide loan. Another factor is the intention of Susan's in giving the additional investment to Bluegill.

In Adelson v. United States (Fed. Cir. 1984) 737 F.2d 1569, the court made a distinction on the difference between a loan and capital. The court stated that “a loan is made upon the reasonable assumption that it will be repaid no matter whether the business venture is successful or not, while capital is put to the risk of the business” (Fed. Cir. 1984) 737 F.2d 1569. Furthermore, the court noted that “the real differences [between a debt and a capital contribution] lie in the debt-creating intention of the parties, and the genuineness of repayment prospects in the light of economic realities” (Fed. Cir. 1984) 737 F.2d 1569. Moreover, in Bauer v. C.I.R. the debate on whether an advance is debt or equity is primarily directed at ascertaining the intent of the parties (9th Cir. 1985) 748 F.2d 1365, 1367). Read More