Rocky and Sandra (shareholders) each loan Eagle Corporation $10,000 at the market rate of 10% interest. Which of the following statements are false?
A) Eagle may deduct the interest expense, and the interest income is taxable to Rocky and Sandra.
B) When the note principal is repaid, neither Rocky nor Sandra recognizes gross income from the repayment.
C) If the IRS were successful in reclassifying the notes as equity, the interest payments would not be deductible by Eagle, and Rocky and Sandra would still recognize income.
D) If the IRS were successful in reclassifying the notes as equity, repayment of the note principal to Rocky and Sandra would not qualify for return of capital treatment and would most likely result in dividend income treatment for Rocky and Sandra.
E) All of the above are true.

Question

Quizplus · Accepted Answer

All of the statements are true. Interest expense is deductible for Eagle and interest income is taxable to Rocky and Sandra. When the note principal is repaid, there is no gross income recognition for Rocky and Sandra. If the notes were reclassified as equity, interest payments would not be deductible but Rocky and Sandra would still recognize income. Repayment of the note principal would not qualify for return of capital treatment and would most likely result in dividend income treatment.

Rocky and Sandra (Shareholders) Each Loan Eagle Corporation $10,000 at the Market