Frank, Cora, and Mitch are equal shareholders in Purple Corporation. The corporation's assets have a tax basis of $ and a fair market value of $ In the current year, Frank and Cora each loan Purple Corporation $ The notes to Frank and Cora bear interest of per annum. Mitch leases equipment to Purple Corporation for an annual rental of $
a Will the shareholder loans from Frank and Cora might be reclassified as equity?
Because the loans
the IRS
in reclassifying the debt as equity.
b What other information related to this situation would you want to know before drawing a definitive conclusion?
If the tax basis of Purple Corporation's assets is used, the ratio is
However, if fair market value of its assets is used, the ratio is
Thus, Purple appears
an acceptable debtequity ratio.
One weakness in the taxpayer's argument is that the annual interest paid exactly equals the lease payment, so the IRS
contend that the loan and the lease
economically equivalent and are proportional to shareholdings.
