Stock v. Debt: Classification Issues
Classification issues commonly exist regarding debt versus stock treatment. John McGuire, as a Denver business attorney and tax attorney assists individual investors and businesses regarding this issues. Hopefully, the article below provides useful information.
Substance over form is used in determining whether an instrument received by an investor in exchange for property contributed to a corporation is treated as stock or debt. Thus, the title of “stock” or “debt” alone by the corporation or individual is not necessarily determinative or controlling of the treatment for income tax purposes.
Currently there is no definition in the Internal Revenue Code to determine when an interest in a corporation constitutes debt and when an interest constitutes stock. Therefore, determining how an interest should be labeled and the tax implications is derived through case law as the courts attempt to determine if the investment or instrument more closely resembles a true debt interest or true equity interest.
A debt interest is defined as: a written unconditional promise to pay a principal amount, on demand or before a fixed maturity date, within a reasonable time in the future, with interest payable in all events and no later than maturity. An equity interest is defined as: an investment which places the funds contributed by the investor at the risk of the business, provides for a share of future profits of the business, and gives rights to control or mange the business.
Although courts has established a number of factors and criteria to determine and differentiate between debt and equity interests, no single factor or set of factors allows for a completely accurate and universal determination. Thus, the factors only aid in the interpretation. Each case must be analyzed separately by weighing the facts & circumstances of the case.
The “thinness” of a corporation’s capital structure refers to the ratio of debt to equity. When far more debt has been invested than equity, a corporation is referred to as “thin” and lacking equity contributions from shareholders. Due to the fact a debt to equity ratio can be viewed somewhat subjectively and mechanically, it has been used to create statutory rules that would disallow interest deductions. Issues however, remain such as should only shareholder held debt be included when calculating the ratio, and regarding equity, is market value or tax basis used?
I.R.C. Section 385
Enacted in 1969, IRC Section 385 authorized the U.S. Treasury Department to promulgate regulations governing the determinations of stock v. equity interests in corporations. The Treasury issued proposed regulations multiple times that were to become final, but after criticism, the regulations were never finalized and have yet to be. It appears that boiling down this complex matter into working rules and regulations is a daunting task, and the Treasury, for the time being has moved on to other issues and interests.
I.R.C. Section 163(e)
IRC Section 163 applies to a debt instrument issued at a large discount and thus reflects an unreasonably high interest rate. The large or excessive portion of the discount is deemed and treated as a dividend, and not interest to the investor/recipient and the payor (corporation/entity) is disallowed a deduction for the excessive amount.
This article was prepared by John R. McGuire. John is a business attorney and tax attorney who works with individuals and businesses regarding individual and entity income tax matters to the sale and purchases of businesses. At The McGuire Law Firm a Denver business attorney and tax attorney can assist you with the formation and structure of your entities including debt & equity issues.