American Corporation has two equal shareholders, Mr. Freedom and Brave Inc. In addition to their investments in American stock, both shareholders have made substantial loans to American. During the current year, American paid $100,000 interest each to Mr. Freedom and Brave Inc. Assume that American and Brave have 34 percent marginal tax rates and Mr. Freedom’s marginal tax rate on ordinary in-come is 39.6 percent.
a. Calculate American’s tax savings from deduction of these interest payments and their after-tax cost.
b. Calculate Brave’s tax cost and after-tax earnings from its receipt of interest income from American.
c. Calculate Mr. Freedom’s tax cost and after-tax earnings from his receipt of interest income from American.
d. If an IRS agent concludes that American is thinly capitalized and the shareholder loans should be treated as equity, explain the impact on American, Brave, and Mr. Freedom.
e. Recalculate Brave’s tax cost and after-tax earnings assuming its receipt of interest from American is treated as a constructive dividend.
f. Recalculate Mr. Freedom’s tax cost and after-tax earnings assuming his receipt of interest from American is treated as a constructive dividend.