The tax implications of different financing arrangements is something that growing businesses in need of capital should consider when deciding between issuing debt instruments and selling off equity in the business, but it isn't the only consideration. Typically, debt financing involves borrowing funds from a bank or from the general public by issuing bonds. The equity options include selling shares of stock or taking on additional owners.
Deductible Loan Interest
A common way of financing with debt for both incorporated and unincorporated businesses is to take out a bank loan. No tax implications exist for receiving and repaying the loan funds, though the interest payments are deductible as an ordinary business expense. The deduction's only requirements are that the business be legally responsible for making the payments and that the underlying funds are used for business purposes.
Issuing Bonds and Deducting Interest
A more sophisticated method of debt financing often used by large corporations is to issue bonds to the investors. Bonds are essentially loans that are provided by multiple investors rather than a bank. Bond investors earn money through interest payments that the corporation makes at either fixed intervals or as a single lump sum when the bonds reach maturity -- the day when the principal must be repaid. In some cases, investors receive imputed interest. Imputed interest results when investors lend a corporation less money than they get back when the bond matures; this difference is taxed for investors and deducted by corporations as interest. A significant benefit to corporations is that they get to take annual deductions for a portion of the imputed interest even though no payment occurs until the bond's maturity date, which is always the case with zero-coupon bonds.
Tax-free Equity Transactions
Corporations may choose to sell equity in the business to raise capital by issuing shares of stock. Similar to the inflow of cash from a loan, this transaction has no immediate tax implications to the corporation or to the new shareholders. In the future, however, the shareholder may expect taxable dividend payments during years of profitability, which aren't deductible by the corporation. Although limited liability companies, partnerships and other structures don't issue shares, they can all offer equity to investors in exchange for capital without any immediate tax implications, but these transactions are structured through contracts and agreements rather than with stock.
Other Considerations Unrelated to Taxes
Current and future net inflows and outflows of cash -- which may take into account the tax implications of the financing arrangement -- is usually a significant consideration for businesses weighing the pros and cons of debt vs. equity financing. If, for example, a business doesn't expect the additional capital to increase profits for many years, equity financing may be preferred, as the funds don't have to be repaid, interest doesn't accrue and dividends or other distributions aren't required. When only debt financing is considered, a corporation may lean toward a zero-coupon bond or similar debt instrument, because it doesn't have to repay the loan for a number of years. But with equity, there's always the drawback of business owners having to dilute their shares of ownership in a business they've created.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.