Academic journal article Journal of Accountancy

Courts Try to Distinguish Debt from Equity: The Age-Old Question Continues

Academic journal article Journal of Accountancy

Courts Try to Distinguish Debt from Equity: The Age-Old Question Continues

Article excerpt

Federal income tax law treats debt and equity differently; primarily, interest payments on debt are deductible, while dividend payments are not. Whether a corporate investment (despite its formal label) is debt or equity for tax purposes is a factual question with no clear answers. CPAs with corporate clients should be aware of a recent case.

OVERVIEW

While there are no current Treasury regulations on the debt vs. equity issue, in 1992 Congress enacted IRC section 385(c), requiring a corporate instrument's characterization as debt or equity by the issuer to be binding on both the issuer and the holder, unless successfully challenged by the IRS. Thus, resolution of the matter is left primarily to the courts.

RECENT CASE

Indmar Products Co., 444 F3d 771 (6th Cir. 2006), rev'g TC Memo 2005-32, illustrates the lack of judicial symmetry in dealing with the debt-equity issue. There, the Tax Court held that certain shareholder cash advances labeled as loans were really equity, thereby denying the corporate taxpayer interest expense deductions on the repayments. (For the facts of Indmar, see "Cash Advances to a Corporation: Loan or Capital Contribution?" page 73.) It applied the 11-factor test set forth in Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986), and found the following five factors critical: (1) The notes had no fixed maturity date or fixed obligation to repay; (2) repayment was likely contingent on corporate profitability; (3) the loan was unsecured; (4) the taxpayer did not establish a sinking fund for repayment; and (5) there was no unconditional and legal obligation to repay at the time the advances were made. …

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