Attorney Harris Livingstain is a member of the Trusts, Estates and Elder Law Team at the Firm. Harris tackles issues relating to estate planning, as well as trust and probate administration. His practice ranges from the very simple to very complex multi-generational estates where his focus is on estate and income tax reduction and asset protection. Harris also represents owners of closely-held or family businesses and assists them in succession to succeeding generations. Where appropriate, he also helps develop strategies for the sale of a family business to a third party. He has been successful in representing fiduciaries of estates and trusts in gift and estate tax audits.
Below is the article Harris has written about some important considerations when using different forms of capital. There are pitfalls where people and businesses can get into uncomfortable tax situations.
“The Debt vs. Equity Dilemma”
In the business context, “debt” and “equity” essentially represent different forms of capital, each with its own tax and legal consequences. The core legal differences between debt and equity are found in the rights, risks, and rewards conveyed to the holder.
Equity is a form of capital that gives the holder a share of ownership in the business, subject to both full business risk and full business upside. Thus, equity holders are legally entitled to payment only out of earnings or, in the case of liquidation, out of assets, but subject in both cases to the claims of debt holders.
The holder of “debt” (the creditor), in contrast, has an absolute legal right to repayment of “debt” regardless of the debtor’s ability to make that repayment out of earnings (although as a practical matter, the creditor will not be paid if assets are unavailable). Usually, the creditor also has an absolute right to payment of interest on principal as well, but debt is governed by contract between the creditor and debtor.
The significance to a taxpayer of debt or equity classification depends on the specific facts of the taxpayer’s situation, because each classification brings its own set of consequences. Key differences in tax consequence involve deductible interest expense by the borrower, treatment of losses by the lender and can be extremely important if the borrower is an entity that has elected to be taxed as an “S” corporation.
A recent Tax Court case, Michael J. Burke and Jane S. Burke v. Comm’r, U.S. Tax Court, Feb 21, 2018, the Tax Court upheld the IRS’s denial of losses claimed with respect to advances made to a business that ultimately failed. The taxpayer advanced funds to a friend involved in a scuba-diving business. At the time the funds were advanced, the business venture was not financially stable. The issue was whether or not the advances of cash were a loan (debt) or capital contributions (equity). If loans, upon the failure of the business, the amounts were deductible as a loss. If capital contributions, the amounts were not deductible.
The IRS disallowed the loss. The court agreed with the IRS and held the advances lacked the indicia of a loan and were therefore not deductible. This case is a good reminder of what the IRS and courts will examine when determining if advances of money are a loan or an equity investment. And it’s a great blueprint of what clients must document to assure debt treatment, if that is in fact the intent of the parties.
In the “S” corporation context, unless certain safe harbor requirements are met, debt is recharacterized under Treas Reg. §1.1361-1(1)(4)(ii) as a second class of stock if (i) the arrangement constitutes equity or otherwise results in treatment of the holder as the owner of stock under general principles of federal tax law and (ii) a principal purpose of the arrangement is to circumvent the rights to distribution or liquidation proceeds or the limitation on eligible shareholders. In most instances, a taxpayer can avoid the second-class-of-stock problem by meeting one of the safe harbor requirements in Treas Reg §1.1361-1(1), (4) and (5). Because this is not always possible, however, a review of the old case law and Code Section 385 is helpful inasmuch as the existence of debt or equity is significant in determining whether there is a second class of stock.
In 1992 (P.L. No, 102-486), Congress amended Section 385 of the Code to provide that the characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or debt, is binding on the issuer and on all holders of such interest, but shall not be binding on the IRS. Such characterization does not apply, however, to any holder of an interest if such holder discloses on his return that he is treating such interest in a manner inconsistent with the characterization made by the issuer. Section 385 is generally consistent with subchapter S and controls the classification of financial instruments as debt or equity for other purposes of the Code. Without regulations under Section 385 formally setting out specific factors to examine in determining the correct character of a purported debt instrument, the following common law factors have evolved over time that may be useful in verifying that an instrument is debt:Whether there is a written unconditional promise to pay on demand or a specified date with a fixed rate of interest, The name given to the instrument and the intent of the parties; The presence or absence of a fixed maturity date; The source of the payments, i.e. whether the recipient of funds can repay the advance with reasonably anticipated cash-flow or liquid assets; Whether the provider of funds has the right to enforce payment of principal or interest; Whether the provider of the funds gains an increased right to participate in management; The status of the provider of the funds in relation to regular creditors; Whether the recipient of the advance is adequately capitalized; Whether there is identity of interest between the provider of funds and the shareholders; Source of interest payments, i.e. whether the recipient of the funds pays interest from earnings; Ability of the recipient to obtain loans from outside lending institutions; The extent to which the recipient uses the advances to acquire capital assets; Whether there is a reasonable expectation of repayment; and Whether the instrument is convertible into stock of the recipient.
It is important for tax as well as business purposes that advances of funds to an entity be properly characterized and treated consistent with the intent of the parties. This intent can generally be discerned by objective factors as discussed above. The attorneys at MWB are uniquely qualified to review your specific situation and make appropriate recommendations to insure compliance with these rules.