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The IRS frequently challenges classification of shareholder advances to a corporation as equity, rather than debt. This article analyzes the various factors used to evaluate this issue and how to protect debt classification of shareholder advances.
Due to tax advantages that make debt more attractive to corporate taxpayers, shareholder advances are often reported as debt, when they more closely resemble equity. The obvious tax avoidance motive for debt classification has resulted in close scrutiny and frequent IRS challenges. The issue is most often raised when a corporation claims an interest expense deduction on a questionable shareholder loan, or a shareholder claims an ordinary deduction for a business bad debt, rather than a capital loss for worthless stock. The numerous court cases addressing the debt-equity question provide evidence of the ambiguity that surrounds it. This article analyzes the debtversus-equity factors and the methods used to evaluate them, and discusses how to protect the debt classification of shareholder advances.
Background
Congress attempted to resolve this controversial issue in 1969 by enacting sec. 385, granting authority to Treasury to issue regulations defining the difference between debt and equity. A list of factors was included to be reflected in the regulations. Treasury issued proposed regulations in 1980 and revisions in 1982.1 All were withdrawn and have not been reissued. As a result, taxpayers must continue to rely on collective input from case law and occasional IRS commentary.
Numerous factors have been used by the courts to evaluate debt-equity cases. In February 2002, the Service issued Field Service Advisory 2002050312 (FSA 2002), describing 12 factors that the Tax Court has relied on ever since to decide whether a debtor-creditor relationship exists. The exhibit on p. 712 lists the factors provided by Sec. 385 and FSA 2002.
The approach typically used by the courts is to weigh each factor in favor of debt or equity, and base the outcome in the direction supported by this analysis. It is impossible to predict which ones will be considered most significant in any individual case; this depends on the facts and circumstances, as well as on the court's perspective.
The risk of reclassification can be greatly reduced or avoided by using planning techniques that consider these authoritative factors and the manner in...