The Internal Revenue Service (“IRS”) and the Department of the Treasury issued proposed regulations under section 385 of the Internal Revenue Code (“Code”) in April 2016. Section 385 authorizes the Secretary of the Treasury (“Secretary”) to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness for purposes of the Code. The proposed regulations would authorize the Commissioner to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes. They also establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes.

Importantly, the proposed regulations provide that if the specified documentation is not provided to the Commissioner upon request, the Commissioner will treat the preparation and maintenance requirements as not satisfied and will treat the instrument as stock for federal tax purposes.

In this paper we:

1. Review the relevant case law;
2. Describe the essential characteristics of indebtedness; and
3. Explain the proposed documentation requirements.

Case Law

Although enacted in 1969, section 385 did not previously result in regulations. Tax administrators instead relied on developed case law. In the absence of regulations addressing debt versus equity classifications, courts have developed dozens of factors to be used in such analyses. Indeed, the characterization of investments made with the intention to create a debtor-creditor relationship has been the subject of much litigation throughout the years. This litigation is especially prevalent when the corporation is one that is closely-held.(1) Among many cases addressing this issue, we discuss the factors considered in making the debt versus equity determination in two particular cases:

• Estate of Mixon v. United States and
• Fin Hay Realty Co. v. United States.

Estate of Mixon v. United States

In Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972), the taxpayer was both president and one of five directors of a bank. To alleviate a sudden cash requirement resulting from a temporary crisis, the bank procured loans from three other area banks, the taxpayer, and two other directors.  When the bank’s position began improving, it was eventually allowed by the F.D.I.C. to repay these loans.(2)

Dividend income is subject to taxation, while the repayment of a loan or advance results in no tax liability to the contributor.(3) As such, the IRS sought to characterize the funding as a capital investment rather than a debt instrument. The Court looked to thirteen factors established by decisions within the same circuit:(4,5)

1. The names given to the certificates evidencing the indebtedness: The issuance of a stock certificate indicates an equity contribution, while the issuance of a bond, debenture, or note is indicative of bona fide indebtedness.(6)
2. The presence or absence of a fixed maturity date: The presence of a fixed maturity date indicates a fixed obligation to repay, which is characteristic of a debt obligation.(7)
3. The source of payments: If corporate earnings are required for repayment to occur, the transaction has the appearance of a contribution of equity capital.(8)
4. The right to enforce payment of principal and interest: Where the obligation to repay the advance is definite, the transaction would have the appearance of a loan.(9)
5. Participation in management flowing as a result: Where making the advance does not grant increased voting power, the transaction would have the appearance of a loan.(10)
6. The status of the contribution in relation to regular corporate creditors: Whether the advance has a status equal to or inferior to that of regular corporate creditors is another determinant in whether the taxpayer was acting as a shareholder or a creditor.(11)
7. The intent of the parties: Tax law not only requires a declaration of intention to create an indebtedness, but also “more than the existence of corporate paper...”(12)
8. “Thin" or adequate capitalization: Thin capitalization is evidence of a capital contribution where the debt to equity ratio was high at the outset, the parties realized that it would go higher, and substantial portions of the funds were used for capital assets.(13)
9. Identity of interest between creditor and stockholder: An equity contribution is indicated where advances are made by stockholders in proportion to their stock ownership.(14)
10. Source of interest payments: Payors do not appear to be seriously expecting interest income where there is failure to insist upon interest payments; rather, they instead appear interested in the future earnings of the corporation.(15)
11. The ability of the corporation to obtain loans from outside lending institutions: The ability to borrow funds from outside sources at the time an advance is made indicates debt.(16)
12. The extent to which the advance was used to acquire capital assets: Advances to provide working capital for daily operations rather than to acquire capital assets indicate debt.(17)
13. The failure of the debtor to repay on the due date or to seek a postponement: Repaying an advance as soon as conditions are met is indicative of debt.(18)

The Circuit Court discussed each of the factors above at length. It found that the facts provided ample evidence of a fixed obligation, and that repayment was anticipated within two years. The source of repayment was not earnings or profits, and repayment was conditioned on reasonably foreseeable events. Additionally, the contributors were not granted increased voting power, and the intent was to meet the operating needs of the bank only until the crisis ended.(19,20) Thin capitalization circumstances were absent, and the funds advanced were not in proportion to the directors' risk capital. Furthermore, while there was no provision for the payment of interest, the transaction was dictated by the F.D.I.C. The last two factors also supported the characterization of the advance as bona fide indebtedness – it was used to provide working capital and was repaid as soon as possible.(21)

Given the Circuit Court’s analysis of the thirteen factors listed above, it affirmed the District Court’s judgment that the advance did not represent a capital investment and was instead legitimate indebtedness.(22)

Fin Hay Realty Co. v. United States

In Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), the case centered around whether certain corporate payments of interest were deductible.(23) The taxpayer in this case, Fin Hay Realty Co., was organized by two individuals when each contributed equal amounts of cash for equal stock ownership in the company. The taxpayer used such funding to complete the purchase of an apartment building.(24)

The IRS disallowed certain deductions previously taken under its finding that the payments represented a stock interest rather than debt. The taxpayer brought an action in District Court, where the court denied its claims. The taxpayer appealed to the Circuit Court.(25)

The Circuit Court noted sixteen factors that had been isolated by prior courts and commentators in judging whether the true nature of an investment is a debt: the intent of the parties; the identity between creditors and shareholders; the extent of participation in management by the holder of the instrument; the ability of the corporation to obtain funds from outside sources; the "thinness" of the capital structure in relation to debt; the risk involved; the formal indicia of the arrangement; the relative position of the obligees as to other creditors regarding the payment of interest and principal; the voting power of the holder of the instrument; the provision of a fixed rate of interest; a contingency on the obligation to repay; the source of the interest payments; the presence or absence of a fixed maturity date; a provision for redemption by the corporation; a provision for redemption at the option of the holder; and the timing of the advance with reference to the organization of the corporation.(26)

In analyzing these factors under the circumstances of the case, the Circuit Court emphasized the corporation’s closely-held status. When “the same persons occupy both sides of the bargaining table,” form may not mirror substance.(27) To determine economic reality, it may be useful to compare the form with a similar transaction that would have taken place between third parties. In this case, the Circuit Court noted that the two initial shareholders had the power to create whatever appearance would provide the greatest tax benefit. After an analysis of all factors laid out, the Circuit Court affirmed the ruling of the District Court.(28)

Essential Characteristics of Indebtedness

The Treasury Department and the IRS have sought to “distill” the different factors from case law into four essential characteristics of indebtedness:

1. A legally binding obligation to pay;
2. Creditors’ rights to enforce the obligation;
3. A reasonable expectation of repayment at the time the interest is created; and
4. An ongoing relationship during the life of the interest consistent with arm’s-length relationships between unrelated debtors and creditors.

Treasury and the IRS have determined that timely documentation and financial analysis evidencing these four essential characteristics of indebtedness are a necessary factor in characterizing a covered related-party interest as indebtedness for federal tax purposes. Preparation and maintenance of this documentation and information are not dispositive. That is, they are a necessary but not necessarily a sufficient condition for treating an instrument as indebtedness.

The documentation and financial-analysis requirements will apply for an interest issued in the form of debt that is an expanded group interest (“EGI”). EGI means “an applicable instrument an issuer of which is one member of an expanded group and the holder of which is another member of the same expanded group.”(29) “Expanded group” means an affiliated group as defined in section 1504(a), determined:

• Without regard to paragraphs (1) through (8) of section 1504(b);
• By substituting “directly or indirectly” for “directly” in section 1504(a)(1)(B)(i); and
• By substituting “or” for “and” in section 1504(a)(2)(A).

The requirements would apply only to large taxpayer groups. An EGI is not subject to Prop. Reg. Sec. 1.385-2 unless the stock of any member of the expanded group is publicly traded, all or any portion of the expanded group’s financial results are reported on financial statements with total assets exceeding USD 100 million, or the expanded group’s financial results are reported on financial statements that reflect annual total revenue that exceeds USD 50 million.

Proposed Documentation Requirements

Treasury and the IRS have noted that third-party borrowing generally requires considerable documentation. They have been concerned that lending in the related-party context may not impose the same level of discipline on legal documentation and economic analysis. The lack of regulations under section 385 further provides little guidance on the information necessary to support the characterization of a purported debt instrument as indebtedness in the related-party context. Of particular concern is guidance on analyzing and documenting a reasonable expectation of repayment at the time an interest is issued.

Treasury and the IRS have sought to require timely documentation and financial analysis that is similar to the documentation and financial analysis created when indebtedness is issued to third parties. The proposed documentation requirements are organized into four categories reflecting the essential characteristics of indebtedness for federal tax purposes:

• Binding obligation to repay;
• Creditor’s rights to enforce the terms of the EGI;
• Reasonable expectation that the advanced funds can be repaid; and
• Actions evidencing a genuine debtor-creditor relationship.

Prescribed documentation and information must be provided with respect to each category. The documentation must include “complete and (if relevant) executed copies of all instruments, agreements and other documents evidencing the material rights and obligations of the issuer and holder relating to the EGI, and any associated rights and obligations of other parties, such as guarantees and subordination agreements.”(30)

We describe each category below.

Binding Obligation to Repay

The documentation must establish that “the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.”(31) There must be some type of binding legal obligation to repay the funds advanced. The proposed regulations would require evidence of such an obligation in form of timely prepared written documentation executed by the parties. For example, a detailed and thorough intercompany agreement would be an import part of this documentation.

Creditor’s Rights to Enforce Terms

The documentation must establish that “the holder has the rights of a creditor to enforce the obligation.”(32) The proposed regulations further provide that the “rights of a creditor typically include, but are not limited to, the right to cause or trigger an event of default or acceleration of the EGI (when the event of default or acceleration is not automatic) for non-payment of interest or principal when due under the terms of the EGI and the right to sue the issuer to enforce payment.”(33) Also, the rights of a credit “must include a superior right to shareholders to share in the assets of the issuer in case of dissolution.”(34)

These provisions need to be built into the documentation, including intercompany agreements. The documentation must also establish that the creditor/holder has the legal rights of a creditor to enforce the terms of the EGI. These rights could include, for example, the right to trigger a default and the right to accelerate payments. Additionally, the creditor’s rights might include a superior right to shareholders to share in the assets of the issuer in the event the issuer is dissolved or liquidated.

Reasonable Expectation of Repayment

The documentation must establish that “as of the date of issuance of the applicable instrument and taking into account all relevant circumstances all relevant circumstances (including all other obligations incurred by the issuer as of the date of issuance of the applicable instrument or reasonably anticipated to be incurred after the date of issuance of the applicable instrument), the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the terms of the applicable instrument.”(35)

This documentation category requires the greatest amount of economic and financial analysis. The regulations provide the following examples of information that may be included in the documentation:

• Cash flow projections;
• Financial statements;
• Business forecasts;
• Asset appraisals;
• Determination of debt-to-equity and other relevant financial ratios of the issuer in relation to industry averages; and
• Other information regarding the sources of funds enabling the issuer to meet its obligations pursuant to the terms of the applicable instrument.

The taxpayer will need to develop and document the appropriate analysis to demonstrate that there is a reasonable expectation of repayment of the debt.

Genuine Debtor-Creditor Relationship

The taxpayer will need to prepare and maintain timely evidence of an ongoing debtor-creditor relationship. This documentation can take two forms:

• In the case of issuer that complied with the terms of the EGI the documentation must include the timely documentation of any payments on which the taxpayer relies to establish such treatment under general federal tax principles.
• In the case of issuer that failed to comply with the terms of the EGI, either by failing to make required payments or by otherwise suffering an event of default under the terms of the EGI, the documentation must include evidence of the holder’s reasonable exercise of the diligence and judgment of a creditor.

Timing

Under the proposed regulations, the documentation must be prepared no later than thirty calendar days after the date of the relevant event, which is generally the later of the date the instrument becomes an EGI or the date that an expanded group member becomes an issuer with respect to an EGI.

However, in case of documentation of the debtor-creditor relationship, the regulations allow the documentation to be prepared up to 120 calendar days after the payment or relevant event occurred.

Maintenance Requirement

The documentation and information in the four categories must be maintained for all taxable years that the EGI is outstanding and until the period of limitations expires for any return with respect to which the federal tax treatment of the EGI is relevant.

Failure to Maintain

An EGI will treated for federal tax purposes as stock if the documentation and information are not prepared or the maintenance requirements are not satisfied. If the requirements are satisfied, general federal tax principles apply to determine whether, or the extent to which, the EGI is treated as indebtedness for federal tax purposes. Determination will take into account the documentation and information prepared, maintained, and provided as well as any additional facts and circumstances.

Reasonable Cause Exception

The proposed regulations provide waivers of penalty if the failure to maintain documentation is due to reasonable cause under the principles of Sec. 301.6724-1.

Summary

If the proposed section 385 regulations are issued as final in their current form, they will require taxpayers to prepare considerably greater documentation and financial analysis to have related-party interests treated as indebtedness for federal tax purposes.

The opinions expressed in this paper are those of the authors and not necessarily those of Economics Partners, LLC.

END NOTES

1. See J. S. Biritz Construction Co. v. Comm’r, Joseph S. Biritz and Dorothy Biritz v. Comm’r, 387 F.2d 451 (8th Cir. 1967).
2. See Estate of Mixon v. U.S., 464 F.2d 394 (5th Cir. 1972).
3. See id.
4. See id.
5. The 11th Circuit Court has utilized the same test. See Stinnett's Pontiac Serv., Inc. v. Comm'r, 730 F.2d 634, 638 (11th Cir.1984) (citing Estate of Mixon v. U.S., 464 F.2d 394, 402 (5th Cir. 1972)).
6. Id. (citing Montclair, Inc. v. Comm’r, 318 F.2d 38 (5th Cir. 1963)).
7. See id. (citing Tyler v. Tomlinson, 414 F.2d 844 (5th Cir. 1969)).
8. See id. (citing Harlan v. U.S., 409 F.2d 904 (5th Cir. 1969)).
9. See id. (citing Campbell v. Carter Foundation Production Co., 322 F.2d 827 (5th Cir. 1963)).
10. See id.
11. See id. (citing Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967); S. v. Henderson, 375 F.2d 36 (5th Cir. 1967); U.S. v. Snyder Brothers Co., 367 F.2d 980 (5th Cir. 1966); Montclair, Inc. v. Comm’r, 318 F.2d 38 (5th Cir. 1963); Rowan v. U.S., 219 F.2d 51 (5th Cir. 1955); Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders 123 (2d ed.)).
12. See id. (citing Tyler v. Tomlinson, 414 F.2d 844 (5th Cir. 1969)).
13. See id. (citing S. v. Henderson, 375 F.2d 36 (5th Cir. 1967)).
14. See id. (citing Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967)).
15. See id. (citing Curry v. U.S., 396 F.2d 630 (5th Cir. 1968).
16. See id. (citing Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967)).
17. See id.
18. See id.
19. See id.
20. See id.
21. See id.
22. See id.
23. See Fin Hay Realty Co. v. U.S., 398 F.2d 694 (3d Cir. 1968).
24. See id.
25. See id.
26. See id. (citing S. Biritz Construction Co. v. Comm’r, Joseph S. Biritz and Dorothy Biritz v. Comm’r, 387 F.2d 451 (8th Cir. 1967); Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967); Smith v. Comm’r, 370 F.2d 178 (6 Cir. 1966); Gilbert v. Comm’r, 262 F.2d 512 (2 Cir. 1959); 4A Mertens. Law of Federal Income Taxation, §§ 26.10a, 26.10c (1966)).
27. See id.
28. See id.
29. Reg. Sec. 1.385-2(a)(4)(ii).
30. Reg. Sec. 1.385-2(b)(2).
31. Reg. Sec. 1.385-2(b)(2)(i).
32. Reg. Sec. 1.385-2(b)(2)(ii).
33. See id.
34. See id.
35. Prop. Reg. Sec. 1.385-2(b)(2)(iii).