Thin Capitalization

Thin Capitalization means:
capitalization derived primarily by loans from the shareholders of a corporation rather than by stock investment. A company or corporation is said to be “thinly capitalised” when its equity capital is small in comparison to its debt capital. The main tax advantage attempted is that the distributions of interest on corporate debt may be deducted by the corporation as interest, whereas distributions on stock are nondeductible dividends. There are three major ways to “thin” the capitalization of a closely held corporation: (1) the initial capitalization may be thin, (2) stockholders can make loans to the corporation, and (3) the shareholders may guarantee outside loans. If the debt-to-stock ratio becomes excessive, the U.S. Internal Revenue Service may contend that the capital structure is unrealistic and the debt is not bona fide. The acceptable debt-to-stock ratio varies according to industry norms. If the corporation's debt is recast as stock, the corporation loses its deductible interest expense. See also thin corporation. Former IRC (check if this IRC provision is current here) §385.

See Dividend in the American Legal Encyclopedia and Dividend in the World Legal Encyclopedia.