Capital structure optimization

Area 3: Advanced Tax Concepts (10-20%)

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Topics

Debt vs. equity classification
Section 385 regulations
Interest expense limitations (Section 163(j))

Lessons

Capital Structure Tax Planning

Study Frameworks

Is the Interest Deductible Under Section 163(j)?

Does the taxpayer meet the small business exception (average annual gross receipts of $30 million or less for 3 prior tax years)?

Yes

Section 163(j) does NOT apply — all business interest expense is fully deductible without limitation

Is the taxpayer a real property trade or business or farming business that has elected out of Section 163(j)?

Yes

Section 163(j) does NOT apply — interest is fully deductible, but ADS depreciation is required (40-yr nonresidential real property, 30-yr residential, 20-yr QIP). Election is irrevocable.

Does the business interest expense exceed the sum of business interest income + 30% of ATI (EBIT basis for 2022+)?

Yes

Excess interest is DISALLOWED in the current year — carried forward indefinitely to future years (subject to same 30% limitation). For partnerships: allocated to and tracked at partner level.

All business interest expense is DEDUCTIBLE — the 163(j) limitation is not binding in the current year

Section 163(j) Business Interest Limitation

Deductible Interest = Business Interest Income + (30% x ATI) + Floor Plan Financing Interest

ATI is computed on EBIT basis (2022+): depreciation and amortization NOT added back. Disallowed interest carries forward indefinitely. Small business exception for taxpayers with average annual gross receipts ≤ $30M. Partnerships allocate disallowed interest to partners.

Debt vs. Equity Tax Characteristics

Characteristic	Debt	Equity
Returns to holder	Interest (deductible by payor)	Dividends (not deductible by payor)
Maturity	Fixed date for repayment	No maturity; perpetual
Payment obligation	Unconditional; enforceable	Contingent on earnings and board discretion
Priority in liquidation	Senior to equity	Residual claimant after all debt
Holder voting rights	None (typically)	Voting rights on governance
Reclassification risk	May be reclassified as equity if factors point to disguised equity	N/A
Section 385 documentation	Required for related-party debt (written obligation, creditor rights, repayment evidence)	Not applicable
Proportionality concern	High risk if debt held in same ratio as stock	N/A

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