Ensuring that shareholder debt is not reclassified as equity

Since issuing corporate debt rather than stock can provide tax advantages to both the corporation and the shareholders, it may be beneficial to thinly capitalize the corporation. Thin capitalization means capitalizing a corporation with a nominal amount of capital stock (in most cases, the minimum amount required by state law) and exchanging the remaining shareholder contributions for corporate debt securities. However, to be respected by the IRS, debt financing must have debt-like characteristics.

Thin capitalization is potentially present when the corporation’s ratio of debt to equity could be considered excessive for the industry. Debt-to-equity ratios should be calculated based on fair market values (FMVs) of corporate assets rather than on tax basis or book value (Kraft Foods Co., 232 F.2d 118 (2d Cir. 1956), and Dillin, 433 F.2d 1097 (5th Cir. 1970)). The courts have recognized that conditions vary greatly between industries and even between companies in the same industry. Therefore, judicial decisions have tended to focus more on the ability of corporations to repay purported debt than on identifying a formula approach.

Whether shareholder debt is true debt or equity

It is well established under Sec. 385 and related case law that corporate debt owed to shareholders can at times be treated as equity by the IRS. Sec. 385 summarizes the criteria for determining whether shareholder debt is true debt or equity. It lists the following factors to consider when determining whether a debtor-creditor or corporation-shareholder relationship exists (Sec. 385(b)):

• The existence of a written unconditional promise to pay on demand or on a specified date and to pay a fixed rate of interest;
• The subordination to, or preference over, any other indebtedness of the corporation;
• The ratio of debt to equity of the corporation;
• The ability to convert the debt to corporate stock; and
• The relationship between stock holdings in the corporation and holdings of the interest in question.

Example 1. Evaluating whether debt will be reclassified as equity: B and J are forming BJ Inc. to market a new product. B wants to contribute $75,000 cash in exchange for 75% of the stock. J wants to contribute $25,000 cash in exchange for the remaining 25%. In addition, B and J intend to loan the corporation $450,000 and $150,000, respectively. The loans will be formalized by written documents and will bear interest at the applicable federal rate payable semiannually. B and J want to structure the loans so that principal payments are due annually over a 12-year period. If cash f low problems arise, the shareholders plan to forgo all principal and interest payments or have the corporation make payments based on cash f low at that time. Another alternative is the conversion of their debt into preferred stock.

The combination of the following factors indicates that the corporate/shareholders debt could be treated (reclassified) as equity by the IRS:

• The ratio of shareholder debt is the same as the ratio of stock ownership (both 75% by B and 25% by J);
• The inside debt-to-equity ratio at the time of contribution is high ($600,000 of debt to $100,000 of capital);
• The shareholders intend to stop interest and principal payments on the shareholder loans if the cash is needed to make payments to other creditors; and
• The debt may be converted to preferred stock if the corporation runs into difficulty.

Example 2. Avoiding the reclassification of debt as equity: Assume the same facts as in Example 1. The risk of reclassification of the debt as equity can be reduced by implementing some of the following changes:

• If feasible, vary the ratio of shareholder debt from that of stock ownership. For example, BJ Inc. could borrow $540,000 from B and $60,000 from J. This would result in substantially different ratios of shareholder debt; i.e., B would hold 75% of BJ Inc.’s stock and 90% of the corporate debt, while J would hold 25% of the corporation’s stock and 10% of its debt;
• Capitalize the corporation, in part, with loans from unrelated parties. This would result in a lower inside debt-to-equity ratio;
• Avoid subordinating shareholder debt to other debts. If the corporation has difficulty meeting its obligations in the future, it should try to reduce payments to all creditors proportionately; and
• Eliminate provisions for converting the shareholder debt to equity. In fact, the shareholders’ intentions that the debt not be convertible should be documented, perhaps in the corporate minutes.

In addition, the IRS may scrutinize transactions that provide corporations with significant tax advantages where the tax treatment appears inconsistent with the substance of their capital structures. For example, the IRS may question instruments that provide an issuing corporation with tax benefits associated with debt even though the instruments themselves resemble stock (Notice 94-48).

Meeting IRS requirements for debt status

Notice 94-47 gives the current IRS position on what is necessary for a corporate financial instrument to pass muster as a debt instrument for federal income tax purposes. The IRS will scrutinize financial instruments that are designed to be treated as debt for federal income tax purposes but as equity for financial accounting, regulatory, or credit-rating-agency purposes.

The IRS will give special attention to instruments that (1) have an “unreasonably long maturity” or (2) allow the issuer to repay the instrument’s principal with the issuer’s stock. In evaluating the debt-versus-equity status of a financial instrument, the IRS takes a “facts and circumstances” approach. But, according to Notice 94-47, the IRS specifically considers the following factors:

• Whether there is an unconditional promise to repay a sum certain on demand or at a fixed maturity date in the reasonably foreseeable future (lack of realistic repayment terms similar to what a third-party lender would agree to is an indication the instrument is equity);
• Whether holders of the instrument have the right to enforce the payment of principal and interest (characteristic of debt);
• Whether the rights of the holders of the instrument are subordinated to the rights of general creditors (characteristic of equity, which is legally “last in line” if a corporation experiences financial troubles);
• Whether the instrument gives the holders the right to participate in the management of the corporation (characteristic of equity);
• Whether the corporation is thinly capitalized (if so, the IRS is more likely to attempt to recharacterize even a carefully drafted debt instrument as disguised equity);
• Whether the holders of the instrument and the shareholders of the issuing corporation are the same persons or entities (if so, the financial instrument is more likely to be equity);
• What label (debt or equity) the parties place on the financial instrument; and
• Whether the financial instrument is intended to be treated as debt or equity for nontax purposes (including financial accounting, regulatory, or credit-rating-agency purposes).

Note: No particular factor in this list, standing alone, will conclusively determine the characterization of an instrument. Instead, the weight attached to a factor depends on all facts and circumstances as well as the overall effect of an instrument’s debt and equity features (Notice 94-47).

Although not specifically discussed in Notice 94-47, debt that is convertible into stock has historically been less likely to be viewed as true debt by the IRS than that which has no conversion feature.

Example 3. IRS may view debt instrument as issuance of equity: To achieve its financial goals, Corporation X contributes $20 to a newly formed partnership, PRS, in exchange for a limited partnership interest. A general partner of PRS, GP, contributes $5 to PRS. PRS then issues debt instruments (notes) to third-party investors for $80. PRS uses $100 (of the $105 of raised capital) to buy X’s newly issued preferred stock. X intends to (1) exclude from taxable income its distributive share of the preferred stock dividends paid to PRS because X, in effect, paid the dividend to itself and (2) deduct its distributive share of interest attributable to PRS’s notes. The IRS, however, views the substance of these transactions as simply representing an issuance of preferred stock by X such that X cannot deduct its distributive share of PRS’s interest (Notice 94-48).

Complying with judicial guidance to ensure debt treatment

A case that gives particularly good insight into the valid-loan-vs.-capital transaction issue is Gray, T.C. Memo. 1997-67. This case dealt with situations in which a corporation loaned money to a shareholder-employee (rather than the other way around). Nevertheless, the case identifies guidelines that can also be used to evaluate loans from shareholders to corporations.

In Gray, the taxpayer, Jewell E. Gray, had received $1,827,198 from her wholly owned C corporation in exchange for several promissory notes. Gray was also the president of the corporation during all relevant periods. When she died, only $103,000 had been repaid. Although $816,000 of the debt was overdue, the corporation had not demanded repayment. However, the corporation did lodge a claim against Gray’s estate for the unpaid $1,724,198, which included the overdue amounts.

The IRS contended that the funds withdrawn by Gray actually represented dividends rather than loans. The Tax Court agreed, even though the purported loans were backed up by written promissory notes, recorded as loans receivable on the corporate books, and treated by both Gray and the corporation as loans for federal and state income tax reporting purposes. In addition, Gray had paid interest on the loans, via offsets against dividend and stock redemption payments due her. Despite these favorable factors, the Tax Court gave more weight to the “objective evidence” (lack of adequate collateral, no collection efforts when loans fell past due, and only a relatively small repayment) than to mere written documentation.

The Tax Court identified the following factors as favoring loans between corporations and shareholders (not all of these need to be present for a transaction to be a loan, nor are they all relevant if a shareholder is lending money to a corporation instead of a corporation lending money to a shareholder):

• The shareholder does not have complete control over the corporation (often unavoidable);
• The corporation is under restrictions on how much can be loaned (such as corporate minute resolutions on the maximum amounts that can be loaned to shareholders);
• The corporation has paid dividends during the period that the loans are outstanding;
• The shareholder has the ability to repay the loans and intends to do so;
• The lender enforces collection efforts when purported loans fall past due or at least amends the loan documents to reschedule missed payments;
• The loans are documented with promissory notes or other evidence of indebtedness;
• There is a written loan agreement and a fixed repayment schedule;
• There is adequate collateral for the purported loans;
• The lender and borrower treat the transaction as a loan in their respective financial records; and
• Meaningful amounts are actually repaid.

In Gray, the Tax Court gave great weight to the fact that substantial amounts went past due without any collection efforts occurring. Therefore, it appears that timely, meaningful repayments are a critical factor in proving that a transaction is actually a loan. If scheduled payments cannot be made for any reason, the loan documents should be revised to reschedule them. Any revision to the loan documents should also be reflected in the corporate minutes. No paperwork will outweigh the actions of related parties if they fail to conduct themselves as they would in dealing with unrelated parties.

Documenting loans

Anytime corporate funds are distributed to a shareholder, the potential risk is that the IRS will attempt to characterize all or part of the distribution as a taxable dividend rather than, for example, a loan payment. The primary documentation for an owner investment that is intended to be debt rather than equity should be in the written loan documents and corporate minutes. Furthermore, both parties should follow through in observing the terms of the loan. The minutes should reflect the following when owner debt is issued:

• The need for the borrowing (how the funds will be used);
• Authorization of the borrowing by the corporate officers; and
• A summary of the terms of the borrowing arrangement (interest rate, repayment schedule, loan rollover provisions, etc.).

Contributor

Shannon Christensen, J.D., MBT, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.