How to Use Debt to Lower Taxes for a C Corporation

If you have a new or existing business that operates as a C corporation, and you need more capital, you should consider the tax benefits of using corporate debt instead of corporate equity. The federal tax code favors corporate debt over corporate equity. For shareholders of closely held C corporations, it can be a tax-wise strategy to include in the corporation’s capital structure: debt from outside lenders, and/or debt from the owners.

Tax Rate Factors

Here are some basics. The highest individual federal income tax rate is now 37%. The highest individual federal rate on net long-term capital gains and qualified dividends is now 20%. In addition, higher-income individuals may have to pay the 3.8% net investment income tax on some or all of their investment income, which includes capital gains, dividends and interest.

On the corporate side, the Tax Cuts and Jobs Act (TCJA) set a flat 21% federal income tax rate on taxable income earned by C corporations.

Debt from Outside Lenders

The non-tax advantage of using debt from outside lenders for a C corporation purchase or to add more capital is that shareholders don’t have to put as much of their own money at risk.

Even when shareholders can afford to fund the entire cost with their own money, tax reasons may make that a bad idea. That’s because a shareholder usually can’t take out all or part of a corporate equity investment without facing the risk of double taxation. This happens when the corporation pays tax on its profits and the shareholders pay tax again when the profits are paid out as dividends.

When debt from outside lenders is used in a corporation’s capital structure, it’s less likely that shareholders will need to receive taxable dividends because they’ll have less money invested in the business. The corporate cash flow can be used to pay off the corporate debt, and then the shareholders will own 100% of the corporation with a smaller investment on their part.

Debt from the Owners

If your only interest in a successful C corporation is as an equity owner, double taxation can occur if you want to take out some of your investment. But if you include debt from the owners (money you lend to the corporation) in the capital structure, you have a built-in way to withdraw that part of your investment tax-free. That’s because the loan principal repayments made to you are not taxable. Of course, you have to include the interest payments in your taxable income. But the corporation can deduct the interest expense — unless a rule that limits the interest expense deduction applies, which is unlikely for a small to medium-sized company.

A TCJA change that is not favorable imposed a limit on interest deductions for affected businesses. However, for 2024, a corporation with average annual gross receipts of $30 million or less for the previous three tax years is not subject to the limit.

Example

Let’s say you plan to use your C corporation, which you own by yourself, to buy the assets of an existing business. You plan to pay the entire $5 million cost with your own money — by giving the corporation $2 million in capital (a stock investment), plus lending the corporation $3 million.

This capital structure lets you get back $3 million of your investment as tax-free repayments of corporate debt principal. The interest payments let you get more cash from the corporation. The interest is taxable to you but can be deducted by the corporation, as long as the limit explained earlier doesn’t apply.

This shows the potential federal income tax benefits of using debt in the capital structure of a C corporation. Contact us to explain the relevant details and estimate the tax savings.