Choosing between debt and equity financial instruments often creates a dilemma for clients seeking capital. Financing is generally required when a business is beginning operations, expanding, or suffering from an economic downturn. Advising clients on the potential tax implications of using a purely debt or equity financial instrument is generally straightforward. However, the tax effects become less certain when financial instruments contain both debt and equity characteristics to meet the needs of capital contributors and recipients. The IRS has stated its intent to vigilantly examine hybrid financial instruments. 1
Financial instruments classified as debt allow capital contributors to treat payments received from the business as interest income and nontaxable principal repayments. 2 Capital recipients also benefit from deductions for payments considered to be interest. Comparatively, an equity classification may have less advantageous tax ramifications. The equity contributors will receive dividends, capital gains, or a mixture of the two, depending on the forms of business organization. 3 In these cases, such equity categorization prevents capital recipients from deducting any of their repayments against income. For an S corporation, the business may even lose its small corporation status if previously claimed debt is reclassified as equity and results in more than one class of stock. 4 However, one advantage of an equity classification is that it enables a flowthrough business to allocate income to tax-exempt capital contributors. 5
Appellate court decisions over the past several years demonstrate how the factors in the debt-equity debate can have substantially different impacts upon the final classification when they are examined in a different light. Consequently, analysis of these court cases gives practitioners clearer insights into the judicial determination of debt-equity classifications, thereby helping clients avoid challenges from the IRS.
Financial instruments are often designed to achieve tax benefits of debt while maintaining the appearance of equity for financial or regulatory reporting purposes. This effort to attain the best of both worlds complicates the tax consideration of these instruments. Sec. 385(a) was enacted in 1969 6 and allows for clarification of debt-equity determinations through regulations. Sec. 385(b) specifies the following five factors that Treasury could incorporate at its discretion within the eventual regulations:
- When an instrument contains a written unconditional promise to pay on demand or on a specified date a sum certain of money and to pay a fixed interest rate, it more closely resembles debt.
- Being subordinate to other debt indicates that an instrument represents equity.
- A high debt-to-equity ratio suggests an equity instrument because most creditors would consider it too risky to lend money to a business with a high level of preexisting debts.
- An equity classification is more likely if the holder can convert an instrument into stock.
- Advances contributed by shareholders proportional to their equity holdings are more likely to be deemed equity contributions.
Although it issued regulations in 1982, the IRS never finalized them. 7 Lack of legislative and administrative guidance has led the courts to establish their own criteria for debt-equity classifications. For example, in Estate of Mixon, 8 the Fifth Circuit used the following 13 factors to distinguish debt from equity:
- An instrument labeled as a note is more likely to be considered to represent debt.
- Fixed maturity dates support a debt classification.
- If repayments are primarily tied to the ability to generate earnings, an equity classification is more probable.
- The ability to demand repayment of advanced funds indicates a debt instrument.
- The equity classification would seem more likely if an instrument provides the ability to participate in management.
- Advances subordinate to other corporate loans are closer to the equity classification.
- The instrument’s debt-equity determination should be influenced by evidence of what the parties intended to create.
- An instrument issued to a thinly capitalized business more closely approximates equity because creditors generally pursue more secured investments.
- If a shareholder advances funds in proportion to his or her equity ownership, the instrument resembles an equity contribution.
- An instrument that allows interest payments to be primarily dependent upon the availability of future earnings (i.e., dividend money) is more likely to be considered equity.
- Evidence that a corporation could receive financing from other third-party lenders increases the chance that an instrument will be classified as debt.
- The use of funds for capital outlays indicates debt status, whereas their use for normal operating expenditures represents equity status.
- Actions such as the debtor’s failure to repay on the due date or to seek a postponement demonstrate a lack of concern in making repayments and suggest that the instrument has equity characteristics.
Courts have discretion to either add or delete some factors in their analysis. For instance, the courts used a 16-factor test and an 11-factor test in Fin Hay Realty Co. 9 and Lantz Co., 10 respectively. Except for the intent of the parties, the IRS adopted all the remaining factors in Estate of Mixon in Field Service Advice 200205031. 11 However, it is important to note that the final debt-equity determination should be based on a balanced consideration of all factors instead of any single factor. 12
Appellate Court Opinions
While courts commonly use factor analysis in resolving the debt-equity classification issue, weighing the various factors depends on all the circumstances involved in a particular case. Since there is no formula for weighing these factors, it is not uncommon for an appellate court to reach a different conclusion than the lower court. Nevertheless, the diverse court decisions reveal information that is valuable for management in planning capital structure or litigation strategies.
Note Subordinated to Debt
In Jones, 13 taxpayers owned 90% of the stock of the Associated Doctors Health and Life Insurance Company. With an insurance industry classification, the company was subject to certain state regulations when it needed additional capital. Following the regulations, the company issued $963,000 of surplus capital notes. Under the surplus note specifications, the noteholders received interest and principal payments after the corporation’s surplus reached a sufficient level, an amount specified by state law.
Along with the fact that the taxpayers did not pay the notes on the maturity date, the IRS argued that the liability to the taxpayers was subordinated to other corporate loans. Accordingly, the IRS determined that the taxpayer’s advances should be treated as equity contributions. At trial, the district court agreed with the IRS. On appeal, the Fifth Circuit, citing Harlan, 14 disagreed, holding that the surplus notes should receive debt treatment despite the nondebt characteristics. It pointed out that the company eventually repaid the noteholders, as required in the agreement, while satisfying the state regulation constraints (e.g., subordination) that were designed to protect the insurance policyholders.
In Bauer, 15 the noteholders were officers and sole stockholders of the corporation. Since the company’s incorporation in 1958, there had been several transfers from and repayments to the noteholders. The IRS contended that the advances from 1974 through 1976 were equity contributions rather than loans. The Tax Court ruled in favor of the IRS in light of the high debt-to-equity ratio (92 to 1) and the correlation between the amounts of the advances and the noteholders’ respective ownership levels.
However, based on several factors, the Ninth Circuit reversed the Tax Court’s decision and held that the taxpayers’ advances were bona fide loans. The Tax Court had omitted retained earnings from total equity in its calculation of debt-to-equity ratios, resulting in a substantial understatement of capitalization. In contrast, the Ninth Circuit included the retained earnings in the stockholders’ equity and recomputed the stockholder debt-to-equity ratios, showing ratios of only 1.5:1 in 1974–1975 and 3.6:1 in 1976. The Ninth Circuit further supported its position that from 1974 to 1976 the company would not be considered too risky for an independent lender by noting that its current assets exceeded total liabilities by a minimum of $300,000.
The Tax Court had examined only the gross amount of the advances between 1974 and 1976 when it concluded that the taxpayers made advances corresponding to their initial equity infusion. It ignored the outstanding debt balance at the beginning of the time period and the company’s timely repayments to the taxpayers. After considering these factors, the Ninth Circuit concluded that the advances did not mirror the noteholders’ initial equity holdings.
Use and Repayments of Affiliate’s Advances
The nonprofit taxpayer in Texas Farm Bureau 16 created and advanced funds to one of its nonprofit affiliated organizations to conduct various supporting activities for agriculture-oriented businesses. At trial, the jury concluded that the funds were advanced as loans to the noteholder’s affiliate.
The Fifth Circuit disagreed with the district court and concluded that several objective factors indicated equity contributions by the noteholder based on the agreed-upon facts of this case. Specifically, the repayment schedule was neither fixed nor mandatory; the primary source of repayment was the affiliate’s earnings; the taxpayer’s advances were subordinated to other debt; the funds were used for operating costs rather than capital investments; and the noteholder did not receive a single interest payment from its affiliate.
Repayments Conditional on Specific Events
In Hardman, 17 the taxpayer and her husband owned 89% of Hardman, Inc. After encountering difficulties maintaining a payment schedule for a piece of land she had purchased, the taxpayer sold the property to Hardman, Inc. Under the agreement, the company first reimbursed the taxpayer for all her payments related to the land and took over the responsibility for paying off the remainder of her promissory note. The company also gave the taxpayer one-third of the gain from reselling the land a few years later. The taxpayer treated her one-third share as a capital gain. The IRS contended that the taxpayer’s one-third share was a dividend payment because the land transfer was an equity investment rather than a sale.
The district court noted that unlike a traditional loan financing agreement, there was a lack of certainty about either the amount or the timing of the principal or interest payment to the taxpayer. As a result, the court concluded that the agreement represented a joint venture activity that was made possible with an equity contribution by the taxpayer. However, the Ninth Circuit disagreed because all payments dictated by the agreement were tied to one specific transaction: the resale of the land. The amount of the payments to the taxpayer was also based on the determinable resale value of the land. Furthermore, the company was obligated to pay the taxpayer her one-third share of the resale profits regardless of how the rest of its operations performed. This is not consistent with the standard definition of dividends, which are to be paid from a company’s general operating earnings and profits. After reviewing the case, the Ninth Circuit concluded that the transfer of the land from the taxpayer to Hardman, Inc., was a sale rather than an equity investment. Accordingly, it reversed the district court’s decision and remanded the case to determine the amount of excess tax paid by the taxpayer.
Interest Reported on Tax Return
In Cerand, 18 the taxpayer transferred a substantial amount of money to three related corporations over several years. The taxpayer claimed part of the repayments by the corporations as interest income on its federal income tax return, though there were no formal documents classifying the transfers as debt or equity. The related corporations subsequently became unable to repay the remaining amount of the transferred funds. The taxpayer took a bad debt deduction from ordinary income for the amount that it was still owed. The IRS, on the other hand, argued that the transfers were equity investments and not loans. By the IRS’s reasoning, the losses were only eligible to receive less favorable capital loss treatment.
The Tax Court noted that an equity classification was the most accurate description of the taxpayer’s original transfers based on several factors. First, there was no instrument demonstrating normal loan characteristics (i.e., maturity date, repayment schedule, or interest rate). Second, the repayments from the related corporations had no discernable pattern except being associated with profitability. Third, the taxpayer was deemed to have made a highly risky transfer of funds given that the related corporations were short of capital and had a history of losses. On appeal, however, the D.C. Circuit held that it was inappropriate for the Tax Court to ignore the taxpayer’s treatment of the repayments from the related corporations on its federal income tax return as evidence of a debt relationship. Meanwhile, the D.C. Circuit was unsure of how heavily the Tax Court weighted the other factors in the case. Accordingly, it remanded the case to the Tax Court to reconsider whether the transfers were equity contributions or loans. 19
Terms of Partnership Agreement
General Electric Capital Corporation (GECC) purchased and then leased commercial airplanes to airline companies. 20 Because of commercial airlines’ financial difficulties in the early 1990s, GECC began to look for ways to reduce its risks. As a result, three subsidiaries of GECC (including TIFD III-E, Inc.) formed the Castle Harbour partnership in 1993. Later, the GECC subsidiaries sold part of their partnership interest to two Dutch banks, which were not subject to U.S. tax. Under the arrangement, the Dutch banks were scheduled to receive 98% of operating income, 90% of disposition gains up to $2,854,493, and only 1% of disposition gains after reaching the $2,854,493 threshold. GECC guaranteed the banks repayment of the $117.5 million initial investment and a 9.03587% annual rate of return that could be slightly increased if profits were unusually high. In 2001, the IRS reclassified the two banks as creditors rather than equity partners. This determination allocated all the partnership income to the taxpayer, increasing the taxpayer’s tax liability by $62,212,010.
The district court ruled in favor of the taxpayer, stating that the partnership was not a sham and that the taxpayer was motivated to acquire nondebt capital because further borrowings were not allowed under its covenants with existing lenders. The partnership arrangement permitted the taxpayer to retire $117.5 million of debt, which represented a substantial economic effect of the transaction. The Dutch banks participated in the partnership’s profits with unlimited upside potential, even with some guarantee against loss. Finally, the court’s debt-equity analysis supported the taxpayer’s position that the Dutch banks’ interest was closer to equity than to debt.
On appeal, the Second Circuit 21 reversed the district court’s opinion and held that the IRS properly denied the partnership’s equity characterization for the following reasons. First, the district court did not examine the banks’ interest under the all-facts-and-circumstances test of Culbertson 22 after finding that the partnership was not a sham. Second, the agreement called for the reimbursement of the banks’ initial investment at a stated applicable rate of return regardless of the partnership’s actual performance. Third, in applying the debt-equity analysis, the district court relied heavily on the partnership agreement’s terminology while overlooking its net impact. For example, the partnership agreement afforded the taxpayer the ability to reclassify all income related to any asset from “operating” to “disposition” income and thus essentially negated the banks’ ability to earn a rate of return in excess of the applicable rate (approximately 10%) the parties had agreed to. Finally, the guarantee by GECC eliminated the Dutch banks’ reliance on assets of the partnership or the taxpayer for reimbursements.
Despite the Second Circuit’s reversal, on remand the district court again held that the banks had an equity interest in the Castle Harbour partnership. 23 The court determined that the banks owned “a capital interest in a partnership in which capital is a material income-producing factor,” 24 and therefore, while they might not be partners under Culbertson, they should be recognized as partners under the plain language of Sec. 704.
Facts vs. Intent
Beginning in the 1970s, Indmar Products Co. made monthly payments, based on a 10% annual return, to its stockholders in return for funds transferred to the company. 25 Although the company always treated the advances as loans on the corporate books, it did not establish formal documentation for all the loans until 1993. The company and its stockholders treated the monthly payments consistently for federal income tax purposes, specifically as interest expense and interest income, respectively. However, the IRS contended that the interest payments were disguised dividend payments, thereby denying the taxpayer’s interest deductions.
Relying on the debt-equity factors discussed in Roth Steel Tube Co., 26 the Tax Court determined that an equity classification most accurately described the advances. On appeal, the Sixth Circuit reversed the Tax Court’s decision because the Tax Court had interpreted the 10% annual rate of return as indicating that the shareholders wanted to receive a 10% return on their investment and minimize estate taxes. The Sixth Circuit, in contrast, argued that greater emphasis should be placed on what was done rather than why it was done. Under such a standard, the comparability of the predetermined rate with lending rates was of more importance than the potential motivations for establishing the rate.
The Sixth Circuit also held that the Tax Court should have considered the issuance of notes beginning in 1993 rather than only factoring in the initial absence of notes. It believed that the court had overemphasized the fact that the notes contained neither fixed maturity dates nor obligations to pay because they were payable on demand, and funds obtained through a secured debt with a bank were used in addition to earnings to repay shareholder advances.
Practical Advice from Appellate Court Decisions
These appellate court decisions provide several practical implications for financing plans. Tax practitioners should use the following planning strategies when advising clients who prefer debt status.
State law requirements: Practitioners should review state law requirements for reasonable grounds of claiming a debt status, especially for clients in highly regulated industries. Although state law cannot prevent a federal court from analyzing the tax consequences of a transaction, courts have considered the fact that state law has severely limited the structure of the transaction. 27 In such a case, the courts may disregard the equity characteristics required by state law and regulations.
Debt-to-equity ratio: Practitioners should advise clients to lower their total debt-to-equity ratio (i.e., total liabilities to the shareholder equity) to avoid problems with the “thin or adequate capitalization” factor. 28 One possible way to lower the total ratio is to decrease dividend payouts, thereby increasing the portion of profits retained in the firm.
Identity of interest: Apply the following approaches to reduce the chance of the IRS using the identity of interest factor against the taxpayer. First, prior to the issuance of new instruments, make sure that the total of new and preexisting debt will not too closely mirror the taxpayer’s equity holding level in the firm. Second, outline the repayment schedule to create additional variation between the taxpayer’s debt and equity ownership. Taking into consideration both the preexisting debt and the repayment schedule may allow the taxpayer to take a more favorable position for the identity of interest factor. 29
Courts may classify financial instruments between tax-exempt organizations using a modified form of the traditional factor analysis used for classifying financial instruments between taxpaying entities. 30 For example, “identity of interest between creditor and shareholder” focuses on whether advances from a shareholder are proportional to his or her equity holding. In a similar manner, advances between nonprofit organizations represent an identity of interest when the organizations have common memberships (i.e., some individuals belong to both organizations and/or some individuals serve on the board of both organizations). 31 Therefore, prior to creating a financial instrument between nonprofit organizations, the organization should make an effort to reduce the incidence of common memberships. This increases the probability of a debt classification because the nonprofit organizations will be able to demonstrate a limited symmetry of interest between them.
Fixed maturity date: Condition the repayment of a financial instrument on the occurrence of a specific future event. Making the repayment dependent on such an event overcomes the traditional equity characteristic of no fixed maturity date. In addition, if the future event will generate the funds for repayments (e.g., the sale of property), the source of payments will not depend solely on operating earnings, the traditional source of payments for equity investments. 32
Documentation: Establish consistent documentation of interest to support the debt classification of a financial instrument. Specifically, reporting interest payment and interest income on the borrower’s and creditor’s federal income tax returns, respectively, can show evidence of debt. 33 However, taxpayers should not rely solely on one type of record to secure debt status because no single factor is decisive in debt-equity classifications. 34
Facts vs. intent: If litigation becomes necessary, in some circumstances practitioners should advise taxpayers to focus on fact rather than intent. That is, they should emphasize what was done rather than why it was done. 35 Taxpayers can make an argument on this basis when the IRS is eager to interpret the underlying intent of the transaction at issue.
Reliance on one factor: When a lower court overemphasizes one of the debt-equity factors, its decision is at risk of being reversed. 36 Therefore, if a trial court’s debt-equity analysis appears to rest mainly on one factor, on appeal taxpayers should attack the opinion on this basis and seek to illustrate the importance of other analysis factors that are favorable to the taxpayer.
Classification: Taxpayers might challenge the IRS classifications in light of TIFD III-E, Inc. (although this case’s reasoning has been criticized). 37 Partnerships with foreign partners may claim refunds of withheld taxes after recharacterizing foreign partnership interest as debt. And corporations may reclassify preferred stock as debt, thereby treating preferred stock dividends as interest expenses for deductions.
Debt or equity reclassification can significantly alter the intended tax consequences of financial instruments. Unfortunately, the absence of a quantitative method of weighing relevant factors within legislative and administrative authority sources has resulted in an extensive amount of litigation regarding debt-equity classifications. The analysis of several appellate court cases provides guidance on the debt-equity classification issue. For example, the lack of flexibility under state statutes can allow instruments to be treated as debt despite having equity attributes. The absence of a known maturity date can also be counterbalanced by making repayments contingent on a certain event. Measuring debt under an aggregate approach and over the time the debt and related debt are outstanding (rather than at one point in time) creates further planning opportunities for clients. In addition, traditional debt-equity factors have been shown to have relevance to nonprofit organizations.
The synthesis of the consequences from these court cases is valuable for those either defending current instruments from being reclassified or designing future instruments. The courts are continuing to develop the rules for debt-equity analysis. Accordingly, practitioners should pay attention to any emerging trends from future cases when advising their clients.
1 Notice 94-47, 1994-1 C.B. 357.
2 Interest income is taxed at ordinary income tax rates.
3 Secs. 731(a) and (b) and 741 cover partnerships; Secs. 1368(b) and (c) address S corporations; and Secs. 301 and 302 regulate C corporations.
4 Sec. 1361(b)(1)(D). However, the straight debt safe-harbor rules under Sec. 1361(c)(5) can prevent some reclassifications from resulting in a second class of stock.
5 For additional tax considerations between debt and equity financing, see Helleloid, Weber, and Cleveland, “Capitalizing Closely-Held Corporations: Updating the Debt vs. Equity Issue,” 27 J. Corp. Tax’n 143 (Summer 2000).
6 Tax Reform Act of 1969, P.L. 91-172, §415(a).
7 See T.D.s 7747, 7774, 7801, 7822, and 7920.
8 Estate of Mixon, 464 F.2d 394 (5th Cir. 1972).
9 Fin Hay Realty Co., 398 F.2d 694 (3d Cir. 1968).
10 Lantz Co., 414 F.2d 1330 (9th Cir. 1970).
11 Field Service Advice 200205031 (2/1/02).
12 John Kelly Co., 326 U.S. 521 (1946).
13 Jones, 659 F.2d 618 (5th Cir. 1981).
14 Harlan, 409 F.2d 904 (5th Cir. 1969).
15 Bauer, 748 F.2d 1365 (9th Cir. 1984).
16 Texas Farm Bureau, 725 F.2d 307 (5th Cir. 1984).
17 Hardman, 827 F.2d 1409 (9th Cir. 1987).
18 Cerand, 254 F.3d 258 (D.C. Cir. 2001).
19 Again, the Tax Court in Cerand, T.C. Memo. 2001-271, held the transfers to be equity contributions because the sporadic reporting of interest, which was not uniform in amount or percentage with an average far below the market rate, was inadequate evidence to support the finding of bona fide loans.
20 TIFD III-E, Inc., 342 F. Supp. 2d 94 (D. Conn. 2004).
21 TIFD III-E, Inc., 459 F.3d 220 (2d Cir. 2006). For detailed analyses of this case, see, e.g., Lipton and Austin, “Partner or Lender? Debt/Equity Issues Arise in Second Circuit’s Reversal of Castle Harbour,” 105 J. Tax’n 236 (October 2006); and Weiner and Campbell, “Right Results? Wrong Theories! Coltec Industries and Castle Harbour,” 34 J. Corp. Tax’n 12 (January–February 2007).
22 Culbertson, 337 U.S. 733 (1949).
23 TIFD III-E, Inc., No. 3:01cv1839 (SRU) (D. Conn. 10/23/09).
24 Sec. 704(e)(1).
25 Indmar Products Co., 444 F.3d 771 (6th Cir. 2006).
26 Roth Steel Tube Co., 800 F.2d 625 (6th Cir. 1986).
27 See Jones, note 13 above.
28 See Bauer, note 15 above.
30 See Texas Farm Bureau, note 16 above.
32 See Hardman, note 17 above.
33 See Cerand, note 18 above.
34 See Cerand, note 19 above.
35 See Indmar Products Co., note 25 above.
36 See Hardman, note 17 above, citing Lantz Co., 424 F.2d 133 (9th Cir. 1970).
37 See, e.g., Lipton and Austin, “Partner or Lender?” and Weiner and Campbell, “Right Results?”
Wei-Chih Chiang is an assistant professor of accounting in the A.R. Sanchez Jr. School of Business at Texas A&M International University in Laredo, TX. Hui Di is an assistant professor of finance and Steven Hanke is an assistant professor of accounting in the Doermer School of Business at Indiana University–Purdue University Fort Wayne in Fort Wayne, IN. For more information about this article, contact Prof. Hanke at email@example.com.