Debt vs. equity in the Tax Court.

• Author: Borghino, Jeff

The classification of an instrument as debt or equity affects numerous tax law provisions. While there is a lack of guidance From the IRS on determining whether an instrument constitutes debt or equity, there are many cases that have established a list of factors that assist taxpayers in making such a determination. Recently, the Tax Court applied those factors in PepsiCo Puerto Rico, Inc., T.C. Memo. 2012-269. This item summarizes the current law and discusses the PepsiCo court's facts and analysis.

Section 385

Congress enacted Sec. 385 in 1969 (amending it in 1989 and 1992) and gave the IRS authority to issue regulations to determine whether an interest in a corporation constitutes debt or stock in the corporation (i.e., debt or equity). The IRS, however, has not issued any regulations since T.D. 7747 was withdrawn in 1983 (T.D. 7920).

The Dixie Dairies Factors

Notwithstanding (or perhaps because of) the absence of regulations under Sec. 385, many courts have established a list of recurring factors for determining whether an interest constitutes debt or equity. The court in Dixie Dairies Corp., 74 T.C. 476 (1980), had to decide whether advances made by a shareholder to a corporation constituted loans (i.e., debt) or capital contributions (i.e., equity).

In determining that such advances constituted equity, the court identified a list of 13 factors that have developed over time in case law and that are described below:

1. Name or label: "The issuance of a stock certificate indicates an equity contribution; the issuance of a bond, debenture, or note is indicative of a bona fide indebtedness" (Estate of Mixon, 464 F.2d 394,403 (5th Cir. 1972));

2. Fixed maturity date: "The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation. The absence of the same on the other hand would indicate that repayment was in some way tied to the fortunes of the business, indicative of an equity advance" (id. at 404);

3. Source of payments: " [I]f repayment is possible only out of corporate earnings, the transaction has the appearance of a contribution of equity capital but if repayment is not dependent upon earnings, the transaction reflects a loan to the corporation" (id. at 405);

4. Right to enforce payments: "If there is a definite obligation to repay the advance, the transaction would take on some indicia of a loan" (id. at 405);

5. Participation in management (as a result of the advances): "If a stockholder's percentage interest in the corporation or voting rights increase as a result of the transfer, it will contribute to a finding that the transfer was a contribution to capital" (Hardman, 827 F.2d 1409, 1413 (9th Cir. 1987));

6. Status in relation to regular corporate creditors: "Whether the advance has a status equal to or inferior to that of regular corporate creditors is, of course, of some import in any determination of whether taxpayer here was dealing as a shareholder or a creditor" (Estate of Mixon, 464 F.2d at 406);

7. Intent of the parties: "It is relevant whether the parties intended, at the time of the issuance of the debentures, to create a debtor-creditor relationship . The intent of the parties, in turn, may be reflected by their subsequent acts; the manner in which the parties treat the instruments is relevant in determining their character" (Monon Railroad, 55 T.C. 345, 357(1970));

8. Identity of interest between creditor and stockholder: "If advances are made by stockholders in proportion to their respective stock ownership, an equity capital contribution is indicated [citation omitted]. A sharply disproportionate ratio between a stockholder's percentage interest in stock and debt is, however, strongly indicative that the debt is bona fide" (Estate of Mixon, 464 F.2d at 409);

9. Thinness of capital structure in relation to debt: "[T]hin capitalization is very strong evidence of a...