Debt vs. equity: the saga continues.

• Author: Burke, Jennifer R.

U.S. tax law prescribes different tax treatments for debt and equity; the principal distinction is that interest payments on debt are deductible, while dividend payments are not. Unfortunately, determining whether a corporate investment--regardless of its formal label--is debt or equity for tax purposes is a highly factual issue. Despite a large body of case law and rulings, there are no clear rules for making this determination.

Background

In 1969, Congress sought to clarify the rules for distinguishing debt from equity by enacting Sec. 385, authorizing the IRS to promulgate regulations distinguishing them. Although the Service issued such regulations 11 years later, they were withdrawn in 1983. However, to provide some degree of consistency in this area, in 1992 Congress enacted Sec. 385(c), requiring the characterization of a corporate instrument as debt or equity by the corporate issuer to be binding on both the issuer and the holder, unless such characterization was successfully challenged by the IRS. As a result, the ultimate resolution of this difficult issue is still left primarily to the judicial process.

Indmar

The recent Sixth Circuit decision in Indmar Products Co., Inc., 444 F3d 771 (6th Cir. 2006), rev'g TC Memo 2005-32, again illustrates the lack of judicial symmetry in dealing with the debt-equity issue.

Tax Court: In Indmar, the Tax Court held that certain shareholder cash advances denominated as loans were really equity, thereby denying the corporate taxpayer interest expense deductions for payments on these advances. In so holding, the court applied the 11-factor test set forth in Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), and found five of the factors to be most relevant. First, the corporation had no dividend history (not a Roth Steel factor). Second, the notes had no fixed maturity date or fixed obligation to repay. Third, repayment of the loan was likely contingent on corporate profitability. Fourth, the loan was unsecured. Fifth, the taxpayer did not establish a sinking fund for repayment. Finally, there was no unconditional and legal obligation to repay at the time the advances were made.

Sixth Circuit: In a split decision, the appellate court reversed, holding that the Tax Court's factual findings were clearly erroneous. In so holding, it also applied the Roth Steel factors, but found that the factors the Tax Court deemed less relevant were, in fact, more relevant. It held the following factors significant...