Debt or equity financing? Analyzing relevant factors.

• Author: Chiang, Wei-Chih

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)

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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.

Background

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 & different conclusion than the lower court. Nevertheless, the diverse court decisions reveal information chat 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...