Parrott, Inc., a C corporation, is owned by Abner (60%) and Deanna (40%). Abner is the president, and Deanna is the vice president for sales. Parrott, Abner, and Deanna are cash basis taxpayers. Late in the year, Parrott encounters working capital difficulties. Therefore, Abner loans the corporation $810,000 and Deanna loans the corporation $540,000. Each loan uses a 5% note that is due in five years with interest payable annually.
a. Determine the tax consequences to Parrott, Abner, and Deanna if the notes are classified as debt.
b. Determine the tax consequences to Parrott, Abner, and Deanna if the notes are classified as equity.