Corporations & Shareholders

Debt vs. Equity: The Saga Continues

U.S. tax law prescribes different tax treatments for debt and equity; the principal distinction is that interest payments on debt are deductible, while dividend payments are not. Unfortunately, determining whether a corporate investment—regardless of its formal label—is debt or equity for tax purposes is a highly factual issue. Despite a large body of case law and rulings, there are no clear rules for making this determination.

       

Background

In 1969, Congress sought to clarify the rules for distinguishing debt from equity by enacting Sec. 385, authorizing the IRS to promulgate regulations distinguishing them.  Although the Service issued such regulations 11 years later, they were withdrawn in 1983. However, to provide some degree of consistency in this area, in 1992 Congress enacted Sec. 385(c), requiring the characterization of a corporate instrument as debt or equity by the corporate issuer to be binding on both the issuer and the holder, unless such characterization was successfully challenged by the IRS. As a result, the ultimate resolution of this difficult issue is still left primarily to the judicial process.

 

Indmar

The recent Sixth Circuit decision in Indmar Products Co., Inc., 444 F3d 771 (6th Cir. 2006), rev’g TC Memo 2005-32, again illustrates the lack of judicial symmetry in dealing with the debt-equity issue.

Tax Court: In Indmar, the Tax Court held that certain shareholder cash advances denominated as loans were really equity, thereby denying the corporate taxpayer interest expense deductions for payments on these advances. In so holding, the court applied the 11-factor test set forth in Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), and found five of the factors to be most relevant. First, the corporation had no dividend history (not a Roth Steel factor). Second, the notes had no fixed maturity date or fixed obligation to repay. Third, repayment of the loan was likely contingent on corporate profitability. Fourth, the loan was unsecured. Fifth, the taxpayer did not establish a sinking fund for repayment. Finally, there was no unconditional and legal obligation to repay at the time the advances were made.

Sixth Circuit: In a split decision, the appellate court reversed, holding that the Tax Court’s factual findings were clearly erroneous. In so holding, it also applied the Roth Steel factors, but found that the factors the Tax Court deemed less relevant were, in fact, more relevant. It held the following factors significant in determining that the ad-vances were debt: (1) they were consistently treated as debt by the taxpayer in filing returns; (2) external financing was available as an alternative to shareholder financing; (3) the corporation was adequately capitalized (i.e., it had a reasonable debt-to-equity ratio); (4) the advances were not subordinated to all creditors; and (5) they were not made in proportion to the shareholders’ respective equity interests. Further, there was consistent payment of a fixed, reasonable interest rate; a significant portion of the advances were repaid not from corporate profits, but from other loans; and the taxpayer used the advances for its operations.

The Sixth Circuit also found that the Tax Court’s assessment of the factors it believed to be most relevant was largely erroneous. Although the loan documents contained no fixed maturity dates, they were the equivalent of demand loans (which are not uncommon in financing transactions). The initial advances were not evidenced by notes; however, notes were subsequently executed for the years at issue, thereby evidencing a fixed obligation to repay. Also, the court accorded little weight to the absence of a sinking fund as a security device, as it found this factor and the lower court’s emphasis on the fact that the advances were unsecured to be superfluous.

 

The Saga Continues

The lack of judicial symmetry on the debt-equity issue was further demonstrated by the fact that it was a two-to-one decision that contained both a concurring and a dissenting opinion. The dissenting judge pointed out that a reversal of a lower court’s decision on an essentially factual issue (such as debt versus equity) is uncommon; she also acknowledged that it would not have been unreasonable for a finder of fact to have ruled either way. Nevertheless, that judge did not find the Tax Court’s holding to be “clearly erroneous.”

 

Conclusion

In the absence of clear statutory, administrative or judicial guidelines on this issue, practitioners must continue to consider a wide range of factors in advising their clients. The positions recommended clearly will continue to be challenged on occasion by the IRS, ultimately leaving the resolution of the issue in many cases to the vagaries of the judicial process.

From Jennifer R. Burke, B.B.A., Oak Brook, IL