Differentiating Debt From Equity

A tax deduction is permitted for interest paid on business indebtedness. When a closely held corporation borrows money from its shareholders, the loans must be examined carefully to determine whether the transfer is a bona fide loan or a disguised capital contribution. The economics of the transfer must be examined to determine whether an unrelated lender would have entered into a similar agreement. When doubt exists, the taxpayer must prove the transfers represent debt by showing there is an unconditional obligation to repay the amounts transferred.
Indmar Products Co. is a closely held corporation whose shares are owned by members of the same family. From 1987 to 2000 the owners transferred money to the corporation, which treated the transfers as loans. Indmar made monthly payments to the shareholders equal to 10% of the amounts transferred, which it deducted as interest payments. The shareholders included the amounts received as interest income on their tax returns. The transfers were not immediately documented and never were secured. Repayments of “principal” were made when demanded by shareholders based on their financial needs rather than on a predetermined repayment schedule.

The shareholders treated the transfers as demand notes to avoid paying Tennessee income tax on the interest since interest on notes maturing within six months in that state is not subject to tax. Indmar, however, reported the demand notes as long-term liabilities on its financial statements to ensure its current ratio complied with the requirements of its loan agreements. To support the long-term liability classification, the company had its shareholders sign waivers stating they would not demand repayment of principal during the next 12-month period. Nonetheless, they demanded numerous repayments, and payments were made to them. The IRS disallowed the interest deductions for 1998 thru 2000, arguing that the transfers were capital contributions rather than loans. The taxpayer petitioned the Tax Court for relief.

Result. For the IRS. The Tax Court concluded the arrangement between Indmar and its shareholders would not occur between two unrelated parties in an arm’s-length transaction since the taxpayer and its shareholders altered the facts whenever it suited their needs. Furthermore, the 10% return paid to the shareholders was higher than the prime rate during the entire period in question.

The court also applied a list of 11 factors that the Sixth Circuit Court of Appeals had previously used ( Roth Steel Tube Company v. Commissioner, 800 F2d 625) to determine whether transfers made to a corporation represented debt or equity. The court determined the following factors showed debt treatment for the transfers in Indmar: (1) External financing was available to the corporation during the entire period; (2) Indmar was adequately capitalized; (3) the transfers were not subordinated to all creditors; (4) the transfers were not in proportion to the shareholders’ ownership interests; and (5) the transfers were reported as debt by the corporation, but the related monthly payments to the shareholders were reported by them as interest income.

The Tax Court, however, also determined other factors outlined in Roth Steel Tube meant the transfers represented equity. The notes had no fixed maturity date or obligation to repay; the transfers were unsecured; no sinking fund had been established by Indmar to repay the “loans”; and the source of repayment of the notes, based on the testimony of a major shareholder, was corporate profits.

The court also noted Indmar never had paid a dividend during the years in question. Thus it concluded the factors suggesting equity treatment outweighed those showing debt treatment. This finding, combined with the court’s previous determination that the transfers were unlikely to occur between unrelated parties, led the court to conclude that the transfers were equity. Therefore it denied the interest deductions.

Roth Steel Tube provides a clear delineation of the factors that determine whether transfers to corporations are debt or equity. When applying these to a particular factual situation, no one factor is controlling.

Indmar Products Co., Inc., TC Memo 2005-32.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.