Courts Try to Distinguish Debt From Equity

ederal income tax law treats debt and equity differently; primarily, interest payments on debt are deductible, while dividend payments are not. Whether a corporate investment (despite its formal label) is debt or equity for tax purposes is a factual question with no clear answers. CPAs with corporate clients should be aware of a recent case.

OVERVIEW
While there are no current Treasury regulations on the debt vs. equity issue, in 1992 Congress enacted IRC section 385(c), requiring a corporate instrument’s characterization as debt or equity by the issuer to be binding on both the issuer and the holder, unless successfully challenged by the IRS. Thus, resolution of the matter is left primarily to the courts.

RECENT CASE
Indmar Products Co., 444 F3d 771 (6th Cir. 2006), rev’g TC Memo 2005–32, illustrates the lack of judicial symmetry in dealing with the debt-equity issue. There, the Tax Court held that certain shareholder cash advances labeled as loans were really equity, thereby denying the corporate taxpayer interest expense deductions on the repayments. (For the facts of Indmar , see “ Cash Advances to a Corporation: Loan or Capital Contribution? ” page 73.) It applied the 11-factor test set forth in Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), and found the following five factors critical: (1) The notes had no fixed maturity date or fixed obligation to repay; (2) repayment was likely contingent on corporate profitability; (3) the loan was unsecured; (4) the taxpayer did not establish a sinking fund for repayment; and (5) there was no unconditional and legal obligation to repay at the time the advances were made. Further, the taxpayer had no dividend-paying history.

In a close decision, the Sixth Circuit Court of Appeals reversed, holding the Tax Court’s factual findings to be clearly erroneous. It held the following factors significant in determining the advances were debt: (1) The taxpayer consistently treated them as debt in filing returns; (2) external financing was available instead of shareholder financing; (3) the corporation was adequately capitalized (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 court also held that the loan documents were equivalent to demand loans, there was a fixed obligation to repay and the absence of a sinking fund was irrelevant.

CONCLUSION
In the absence of clear guidelines, CPAs must consider a wide range of factors in advising clients. The IRS will continue to challenge the positions they recommend, ultimately leaving resolution to the courts—and, as the above discussion indicates, the courts do not agree.

For more information, see Tax Clinic, “Debt vs. Equity: The Saga Continues,” by Jennifer R. Burke, in the September 2006 issue of The Tax Adviser.

—Lesli S. Laffie, editor
The Tax Adviser