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8.3 Capital Structure: Debt vs. Equity & Section 385 Principles
EA Part 2 — Businesses: Free Study Guide 2026 Exam
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1 Chapter 1: Exam Cycle & Preparation
1.1 Current Exam Cycle, Blueprint & Study Decisions
2 Chapter 2: Business Entity Choices & Classification
2.1 Business Structures & Liability: Sole Proprietorship, Partnership, LLC, and Corporation 2.2 Entity Classification & Check-the-Box Rules (Form 8832) 2.3 Classification Elections, Default Rules & the 60-Month Limitation 2.4 EINs, Entity Changes & Closing a Business
3 Chapter 3: Sole Proprietorships
3.1 Schedule C Gross Income & Allowable Business Expenses 3.2 Self-Employment Tax (Schedule SE) & Statutory Employees 3.3 Business Use of Home (Simplified vs. Actual Method)
4 Chapter 4: Partnership Formation & Basis
4.1 Formation & Property Contributions under Section 721 4.2 Partner Liabilities under Section 752 (Recourse vs. Nonrecourse) 4.3 Partnership Tax Year, Accounting Periods & Form 1065 Filing 4.4 Family Partnerships, Gifted Interests & Income Allocations
5 Chapter 5: Partnership Basis & Loss Limitations
5.1 Outside Basis Calculations & Ordering Rules 5.2 Basis, At-Risk (§465) & Passive Loss (§469) Limitations 5.3 Excess Business Losses (§461(l)) & Related-Party Transactions (§707) 5.4 Debt Discharge: Partnership vs. S Corporation
6 Chapter 6: Partnership Operations & Distributions
6.1 Form 1065, Schedule K & Schedule K-1 Separately Stated Items 6.2 Guaranteed Payments vs. Distributive Shares 6.3 Nonliquidating & Liquidating Distributions & Section 751 Hot Assets 6.4 Centralized Partnership Audits, Notices & Opting Out
7 Chapter 7: Partnership Dispositions & Basis Adjustments
7.1 Sale or Exchange of a Partnership Interest 7.2 Optional Basis Adjustments (Section 754, 743(b) & 734(b)) 7.3 Partnership Terminations, Mergers & Divisions
8 Chapter 8: C Corporation Formation & Structure
8.1 Corporate Formation & Section 351 Transfer Requirements 8.2 Boot, Section 357 Liabilities in Excess of Basis & Section 1244 Stock 8.3 Capital Structure: Debt vs. Equity & Section 385 Principles 8.4 Controlled Groups & Closely Held Corporations
9 Chapter 9: C Corporation Operations & E&P
9.1 Form 1120 Gross Income, Corporate Deductions & 21% Flat Tax Rate 9.2 Book-Tax Differences (Schedule M-1 vs. Schedule M-3) 9.3 Current vs. Accumulated Earnings & Profits (E&P) 9.4 Accumulated Earnings & Personal Holding Company Taxes 9.5 Corporate Minimum Tax & Foreign Tax Credits
10 Chapter 10: C Corporation Distributions & Liquidations
10.1 Property Distributions, Dividends & Constructive Distributions 10.2 Stock Redemptions (§302) & Corporate Liquidations (§331/§336)
11 Chapter 11: S Corporation Eligibility & Operations
11.1 S Corporation Requirements & Form 2553 Election Rules 11.2 Election Deadlines, Late Election Relief (Rev. Proc. 2013-30) 11.3 Form 1120-S Operations, Reasonable Compensation & 2% Shareholder Fringes
12 Chapter 12: S Corporation Basis, Distributions & Taxes
12.1 Stock & Debt Basis Calculations, Ordering Rules & Form 7203 12.2 S Corp Distributions, Accumulated Adjustments Account (AAA) & E&P Tiers 12.3 Entity-Level Taxes (BIG §1374 & Passive Income §1375) & Termination
13 Chapter 13: Accounting Periods & Methods
13.1 Tax Years: Calendar, Fiscal, and 52-53 Week Years 13.2 Cash vs. Accrual Method & Section 448 Gross Receipts Test 13.3 Changes in Accounting Method (Form 3115) & Section 481(a) Adjustments 13.4 2025 Domestic Research Expensing & Foreign Research
14 Chapter 14: Business Gross Income & Inventory
14.1 Gross Receipts & Inclusions in Business Gross Income 14.2 Cost of Goods Sold (COGS) & Inventory Valuation (Cost, LCM, FIFO, LIFO) 14.3 Section 263A Uniform Capitalization (UNICAP) & Small Business Exemption
15 Chapter 15: General Business Deductions & Limits
15.1 Ordinary & Necessary Business Expenses (§162) & Disallowances 15.2 Business Meals, Gifts & Travel 15.3 Vehicle Expenses, Mileage & Substantiation 15.4 Business Interest Expense Limitation (§163(j)) & Business Taxes
16 Chapter 16: Business Losses & Net Operating Losses
16.1 Net Operating Losses (NOLs) 80% Taxable Income Cap & Carryforward Rules 16.2 Business Casualty, Theft & Disaster Losses 16.3 Business vs. Nonbusiness Bad Debts (Direct Write-Off Method §166)
17 Chapter 17: Section 199A Qualified Business Income Deduction
17.1 Section 199A Overview: 20% Deduction & Qualified Trades or Businesses 17.2 Specified Service Trades or Businesses (SSTBs) & Threshold Phase-Outs 17.3 W-2 Wage & UBIA Limitations Calculation & Aggregation Rules
18 Chapter 18: Depreciation Principles & MACRS
18.1 Depreciable Property, Cost Basis & Capitalization vs. Repair Regulations 18.2 MACRS Property Classes (3, 5, 7, 15, 27.5, 39-Year) & Depreciation Methods 18.3 Depreciation Conventions: Half-Year, Mid-Quarter (40% Rule) & Mid-Month
19 Chapter 19: Section 179 Expensing & Bonus Depreciation
19.1 Section 179 Expensing: $2.5M Limit, $4M Phase-Out & Taxable Income Limitation 19.2 2025 Bifurcated Bonus Depreciation: Pre-Jan 20 (40%) vs. Post-Jan 19 (100% OBBBA) 19.3 Listed Property Rules, >50% Business Use & Section 280F Luxury Auto Limits
20 Chapter 20: Amortization & Intangible Assets
20.1 Section 197 Intangibles & 15-Year Straight-Line Amortization 20.2 Start-Up (§195) & Organizational (§248/§709) Expenditures: $5,000 Rule & 180-Month Amortization 20.3 Depletion: Cost Depletion vs. Percentage Depletion for Natural Resources
21 Chapter 21: Business Property Dispositions & Recapture
21.1 Sale of Business Property & Reporting on Form 4797 21.2 Section 1231 Netting Process & 5-Year Lookback Recapture Rule 21.3 Section 1245 (Full Personal Property Recapture) & Section 1250 / Unrecaptured §1250 Gain
22 Chapter 22: Like-Kind Exchanges & Involuntary Conversions
22.1 Section 1031 Like-Kind Exchanges (Real Property Only, 45-Day/180-Day Deadlines) 22.2 Boot Recognition & Basis Calculation for Replacement Property 22.3 Section 1033 Involuntary Conversions & Replacement Periods
23 Chapter 23: Business Tax Credits
23.1 General Business Credit (Form 3800), Net Income Tax Limit & Carryback/Carryforward 23.2 Key Business Tax Credits: Research Credit (§41), WOTC (§51), Small Employer Health (§45R)
24 Chapter 24: Worker Classification & Information Reporting
24.1 Employee vs. Independent Contractor: Common Law Control & Form SS-8 24.2 Section 530 Relief Requirements & Consequences of Misclassification 24.3 Information Returns: Form 1099-NEC vs. 1099-MISC, Form W-2/W-3 & Backup Withholding
25 Chapter 25: Employment Taxes & Compliance
25.1 Form 941 (Quarterly Payroll Tax Return) & Federal Income Tax / FICA Withholding 25.2 Federal Unemployment Tax (Form 940) & State Unemployment Credit 25.3 Payroll Tax Deposit Schedules (Monthly vs. Semi-Weekly, $100K Rule) & Trust Fund Penalty (§6672)
26 Chapter 26: Fiduciary Income Taxation (Trusts & Estates)
26.1 Principles of Fiduciary Income Taxation & Form 1041 Filing Requirements 26.2 Fiduciary Tax Years, Exemptions & Estimated Payments 26.3 Simple and Complex Trusts, Tiers & Distribution Timing 26.4 DNI Computation & Fiduciary Expense Allocation 26.5 Income Distribution Deduction & Schedule K-1 (Form 1041) Flow-Through 26.6 Foreign Trusts, Grantor Control & Abusive Schemes
27 Chapter 27: Tax-Exempt Organizations & Farm Taxation
27.1 Recognition of Tax Exemption (Form 1023/1024) & §501(c)(3) Standards 27.2 Maintaining Exemption, Political Activity & Excess Benefits 27.3 Form 990 Series Annual Returns & Unrelated Business Taxable Income (UBTI / Form 990-T) 27.4 Unrelated Business Income & Debt-Financed Property 27.5 Farm Income, Schedule F & Conservation Costs 27.6 Farm Income Averaging & Conservation Deductions 27.7 Farm Disaster Elections & Livestock Replacement 27.8 Farm Rentals, Estimated Tax & Farm Depreciation
28 Chapter 28: Business Records, Reporting & ACA
28.1 Financial Statements, Records & Owner Transactions 28.2 Filing Extensions, International Forms & Cash Reporting 28.3 ACA Employer Size, Coverage & Reporting
29 Chapter 29: Employer & Self-Employed Retirement Plans
29.1 Qualified Plans, 401(k) Limits & Nondiscrimination 29.2 SEPs, Self-Employed Contributions & Owner Compensation 29.3 SIMPLE IRAs & Small-Employer Contribution Choices 29.4 Plan Reporting, Loans & Prohibited Transactions
30 Chapter 30: Rental Property & Passive Activities
30.1 Rental Income, Expenses & Conversion Basis 30.2 Rental Losses, Active Participation & Real Estate Professionals 30.3 Vacation Homes, Personal Days & Rental Allocations
8.3 Capital Structure: Debt vs. Equity & Section 385 Principles
Key Takeaways Explain This Topic AI
Corporate capital structure balances equity and debt financing, creating sharp federal tax asymmetry: interest expense is deductible by the corporation under §163 (subject to §163(j)), whereas dividends are nondeductible distributions of after-tax earnings.
Repayment of debt principal is a nontaxable return of basis to the creditor under §1001, whereas corporate stock redemptions are presumed to be dividend distributions under §301 unless meeting the exchange tests of §302(b).
IRC §385 authorizes the Treasury and IRS to classify corporate interests as debt or equity based on economic substance rather than formal labels.
Key debt-versus-equity judicial factors include written unconditional maturity dates, fixed market interest rates, subordination to general creditors, debt-to-equity ratios (thin capitalization), proportionality of debt and stock holdings, and availability of third-party bank financing.
Recharacterization of shareholder debt as equity disallows corporate interest deductions under §163, recasts interest paid as constructive dividends under §301/§316, and treats principal repayments as stock redemptions.
Last updated: October 2026
Capital Structure: Debt vs. Equity & Section 385 Principles
When organizing or funding a C corporation, the owners must decide how to structure their capital investment: through equity (issuing shares of common or preferred stock) or through debt (advancing shareholder loans, promissory notes, or issuing debentures). Because the Internal Revenue Code treats debt and equity with profound asymmetry, shareholders frequently attempt to disguise equity investments as corporate debt to secure entity-level deductions and facilitate tax-free extractions of cash.
To police this boundary, Congress enacted IRC §385 , and the federal courts developed an extensive body of common law to determine whether an instrument represents bona fide indebtedness or disguised equity. On the Special Enrollment Examination, candidates must thoroughly understand this tax asymmetry, the primary classification factors, and the severe tax consequences of IRS recharacterization.
The Tax Asymmetry: Debt vs. Equity
The fundamental conflict between debt and equity stems from differing tax treatment at both the corporate and investor levels:
1. Corporate Entity Level
Interest on Debt: Deductible by the corporation as ordinary business interest expense under IRC §163 (or trade/business expense under §162), reducing corporate taxable income. (Note: under IRC §163(j) , interest deductions may be subject to the 30% adjusted taxable income limitation, though small businesses meeting the IRC §448(c) gross receipts test of $31 million for 2025 are exempt).
Dividends on Stock: Nondeductible distributions of corporate earnings and profits (E&P). Dividends are paid entirely out of after-tax corporate dollars, resulting in traditional "double taxation."
2. Investor / Shareholder Level
Interest Received: Taxable to the recipient as ordinary income at graduated tax rates under IRC §61(a)(4).
Dividends Received: For individual shareholders, "qualified dividends" are taxed at preferential long-term capital gains rates (0%, 15%, or 20% under IRC §1(h)(11)). For corporate shareholders, dividends qualify for the Dividends Received Deduction (DRD) under IRC §243 (50%, 65%, or 100% deduction depending on ownership percentage).
3. Return of Investment Capital
Debt Principal Repayment: Nontaxable return of capital/basis under IRC §1001 . The shareholder/creditor receives cash with zero tax consequence (assuming basis equals face value).
Stock Redemption: Subject to the strict requirements of IRC §302 . If a redemption fails to qualify as a substantial reduction or complete termination of interest under §302(b), the entire distribution is treated as a dividend distribution under IRC §301 to the extent of E&P.
4. Loss on Worthlessness or Default
Bad Debt (IRC §166): If corporate debt becomes worthless, a corporate creditor or business individual may claim a business bad debt deduction (ordinary deduction under §166(a)). Nonbusiness bad debts held by individuals are treated as short-term capital losses under §166(d).
Worthless Stock (IRC §165(g)): Treated as a capital loss sustained on the last day of the tax year in which the stock became worthless, unless qualifying for ordinary loss treatment under IRC §1244.
- Structural Feature Corporate Debt Corporate Equity
- Periodic Payments Interest: Deductible by corporation under §163 Dividends: Nondeductible distribution of E&P
- Investor Tax Rate Ordinary income rates Qualified dividend rates (0/15/20%) or §243 DRD
- Principal Repayment Tax-free return of basis (§1001) Taxed under §302 (often dividend under §301)
Entity-Level Tax Drag Eliminates double taxation on earnings paid out Full double taxation (corporate 21% + individual tax)
- Loss upon Failure Bad debt (§166 ordinary or short-term capital) Capital loss (§165(g)), unless §1244 applies
- IRC §385 and Common Law Debt-Equity Factors
Under IRC §385(a) , the Secretary of the Treasury is authorized to prescribe regulations to determine whether an interest in a corporation is to be treated for tax purposes as stock or indebtedness. While comprehensive Treasury regulations have historically faced administrative challenges, courts and the IRS rely on IRC §385(b) and established judicial doctrine across seven primary factors : IRC §385 & Judicial Debt-Equity Spectrum
- ├── 1. Formal Written Instrument (Unconditional Promise to Pay Sum Certain)
- ├── 2. Fixed Maturity Date & Commercially Reasonable Fixed Interest Rate
- ├── 3. Priority over General Creditors (Lack of Subordination)
- ├── 4. Thin Capitalization (Debt-to-Equity Ratio)
- ├── 5. Proportionality (Debt Held in Same Ratios as Stock Ownership)
- ├── 6. Creditor Remedies & Actual Enforcement on Default
- └── 7. Independent Third-Party Commercial Financing Viability
- Detailed Analysis of the Seven Factors
Presence of a Written Promissory Note with Fixed Maturity Date: Bona fide debt is evidenced by a formal written promissory note containing an unconditional promise to pay a sum certain in money on demand or on a specified fixed date in the reasonably near future. The absence of a formal note or an indefinite/excessively long maturity date strongly indicates equity.
Fixed Interest Rate and Definite Payment Schedule: Debt requires a fixed or determinable interest rate that is paid regularly regardless of corporate earnings. If interest is payable only out of corporate profits, or if interest payments are continually skipped or deferred without protest, the advance is treated as equity.
Subordination to General Creditors: If the shareholder's loan is subordinate to the claims of general unsecured trade creditors or commercial banks, the shareholder has accepted an equity-like risk position behind all external lenders.
Thin Capitalization (Debt-to-Equity Ratio): Extreme leverage—where the corporation has a very high ratio of debt relative to equity capital (e.g., 20:1 or 50:1)—indicates that the business was undercapitalized at inception. When debt capital is used to purchase essential long-term operating assets rather than fund temporary working capital, courts treat the purported debt as equity risk capital.
Proportionality of Holdings: If debt is held by shareholders in the exact same proportions as their stock ownership (e.g., three equal 33.3% shareholders each hold 33.3% of the corporate debt), the economic incentive to enforce debt repayment as a genuine creditor is absent. Non-proportional debt (e.g., a 10% shareholder holding 80% of the debt) strongly supports bona fide debt classification.
Creditor Remedies and Enforcement Conduct: A genuine commercial lender enforces default provisions, accelerates notes, or files legal claims when scheduled payments are missed. If the shareholder takes no action to enforce payments during corporate distress, the advance resembles equity capital.
Ability to Obtain Third-Party Commercial Financing: Could an independent commercial bank have loaned the corporation funds under identical terms without demanding personal guarantees or equity warrants? If no independent lender would have extended credit under those terms, the shareholder advance is deemed risk equity.
Consequences of IRS Recharacterization
If the IRS audits the corporation and successfully reclassifies purported shareholder debt as corporate equity under Section 385, the tax consequences are severe and multifaceted:
1. Complete Disallowance of Corporate Interest Deductions
The corporation loses its interest deductions under IRC §163 for all open tax years.
Corporate taxable income is adjusted upward, creating immediate corporate income tax deficiencies, failure-to-pay penalties, and accrued interest.
2. Recasting of Periodic Interest Payments as Constructive Dividends
The payments previously reported as interest are recharacterized as corporate distributions under IRC §301 .
To the extent the corporation has current or accumulated Earnings and Profits (E&P) , the payments are taxed as constructive dividends to the recipient shareholder under IRC §316 .
3. Recasting of Principal Loan Repayments
Repayments of loan principal can no longer be received tax-free under §1001.
Instead, principal payments are treated as stock redemptions under IRC §302 . Unless the shareholder satisfies one of the rigorous disproportionality or complete termination tests under §302(b), the entire principal repayment is treated as a dividend distribution under §301 to the extent of E&P!
4. S Corporation Single-Class-of-Stock Disqualification Risk
If a small C corporation recharacterized under §385 attempts to elect S corporation status under IRC §1362, the recharacterized debt may be treated as a second class of stock, terminating or invalidating the S election under IRC §1361(b)(1)(D) .
To protect against this, taxpayers must comply with the Straight Debt Safe Harbor under IRC §1361(c)(5) (written unconditional promise to pay a sum certain on a specified date, interest rate not contingent on profits, not convertible into stock, and creditor is an eligible individual, estate, or commercial lender).
Section 163(j) Business Interest Expense Limitation (2025 Rules)
Even when corporate debt is fully recognized as bona fide indebtedness, the corporate deduction for interest expense may be restricted by IRC §163(j) :
General Formula: The deduction for business interest expense in any tax year cannot exceed the sum of:
- The corporation's business interest income for the year;
- 30% of the corporation's Adjusted Taxable Income (ATI) ; and
The corporation's floor plan financing interest .
Small Business Exemption: Under IRC §163(j)(3) and IRC §448(c) , taxpayers whose average annual gross receipts for the prior three tax years do not exceed the inflation-adjusted threshold ( $31 million for tax year 2025 ) are exempt from the §163(j) limitation if they are not tax shelters; related-business aggregation rules apply.
Indefinite Carryforward: Any business interest expense disallowed under §163(j) carries forward indefinitely to subsequent tax years.