Advances between affiliated entities: An uphill but winnable battle for loan characterization

Editor: Robert Venables, CPA, J.D., LL.M.

Repeatedly, the IRS has recharacterized an advance between affiliated or commonly controlled entities as a capital contribution rather than the taxpayer’s purported loan — often enough to make a loan characterization seem unattainable.

For tax practitioners, a 2023 Tax Court decision, Allen, T.C. Memo. 2023-86, provides a relatively recent example of the care required to preserve any hope that characterization of a related-party advance as a loan will withstand IRS scrutiny (see also Gottschalk, “Tax Court Rejects Bad Debt Deductions,” 54-10 The Tax Adviser 16 (October 2023)).

The Allen case

The relevant facts in this case are similar to fact patterns in other loan recharacterization cases: An individual owned or controlled several business entities (in this case, S corporations) and caused those S corporations to make various “loans” to one another. When the debtor entity did not repay the purported loans (or make interest payments), the creditor entity took a Sec. 166 bad debt deduction on its tax return. Additionally, the debtor entities did not complete loan applications or have earnings.

After noting that “[a] monetary transfer made between affiliated parties is subject to special scrutiny” (quoting American Underwriters, Inc., T.C. Memo. 1996-548, slip op. at 16), the Tax Court applied the 13 Mixon factors to its equity vs. debt analysis (Estate of Mixon, 464 F.2d 394 (5th Cir. 1972)) and concluded that the weight of the 13 factors indicated that the advances constituted equity and not bona fide debt.

The interesting part of the court’s analysis was not its findings that the weight of the 13 factors supported a “capital contribution” characterization but, instead, its findings that some of those factors did support a loan characterization. For example, calling some of the advances a “future advance promissory note” favored the taxpayer because the taxpayer also was able to articulate the business purpose for the advance, thus fulfilling one of the Mixon factors indicative of debt — the names given to the certificates evidencing indebtedness. Although Sec. 166, which governs the deductibility of bad debts, does not require an actual showing of a business purpose for the debt, having one for an advance to a related entity bolsters the advance’s legitimacy as a business transaction and not simply a tax-avoidance measure.

Likewise, with respect to the Mixon factor of the presence or absence of a fixed maturity date, the court observed that notes with original maturity dates of five to nine years were modified before maturity because the original maturity dates were set to occur during a recession. The court observed that, in instances where a maturity date is repeatedly extended, the factor tends to weigh in favor of equity. However, the court also noted that it has held previously that extending a maturity date to allow a debtor the opportunity to improve its finances is reasonable and held this factor indicative of debt in this case. Thus, in the related-party context, providing a verifiable (and contemporaneously written) reason for a maturity date’s extension further evidences the advance as debt rather than an equity infusion. 

In the taxpayer’s favor, with respect to the participation-in-management factor, the court’s reason for according this factor as supporting characterization of the advances as debt bodes well for most commonly controlled entities. This factor asks whether the purported lender receives an increase in the business’s management as a result of the advance. In Allen, the principal already owned and/or controlled the debtor entities, and, as such, his participation could not have increased any more (similar to the “meaningless gesture” doctrine). Consequently, the very nature of commonly controlled entities’ existence means this factor will generally weigh in favor of a debt finding.

Observations

Although the taxpayer in Allen satisfied a few of the Mixon factors, the real story here is that related-party advances are commonly recharacterized from loans to equity contributions because they simply do not reflect a true lending transaction. And while a funding arrangement between unrelated parties can also lack indicia of debt, the special scrutiny accorded to related-party transactions means there is no room for shortcuts.

Many times, as was the situation in Allen, the transaction documents provide for interest to be paid at a stated time by the debtor entity. While the taxpayer succeeded with this factor in Allen (due to the 2008–2009 recession), the debtor’s failure to make the required interest payments is one obvious signal that the transaction is not a loan for tax purposes, since lack of payment is easily verifiable through books and records.

Another area that requires particular attention is the creditor’s enforcement of the loan, or at least attempts at enforcement. In Allen, as is the case with many related-party loans, the alleged creditor did not act like a creditor. In a true lending transaction, a creditor would make a significant effort to enforce the terms of a loan — both to attempt collecting interest income and principal and to demonstrate that it is justified in taking a bad debt deduction when those attempts fail.

Another common aspect of relatedparty loan practices that does not support loan treatment is continually granting maturity date extensions where a definitive maturity date is stated in the original loan documents. This is more significant when the debtor has not made any interest payments. Based on the Mixon factors, the underlying rationale for this inquiry is that a true lender expects to be repaid its principal, while an investor is willing to take the risk that they will not recoup their investment. As the court acknowledged in Allen, loan modifications with similar terms as the original do not necessarily give rise to a finding that there is no fixed maturity date, so long as the modification is reasonable under the circumstances. In Allen, the reasonable circumstance was the 2008–2009 recession and the creditor’s expectation that the debtor’s financial situation would subsequently improve. Consequently, if a creditor is willing to postpone the principal repayment date, there should be a well-documented business reason for such an extension.

Added scrutiny, but within known boundaries

All related-party transactions are subject to special scrutiny, but related-party funding transactions have the additional burden of being analyzable under the 13 Mixon factors. While these factors require a tax practitioner to do more upfront diligence on a client’s related-party loans, the good news is that the boundaries continue to be well defined.

Editor Notes

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Contributors are members of or associated with Cohen & Co. Ltd.