Planning techniques to avoid the reclassification of shareholder debt as equity.

EXECUTIVE SUMMARY

* Shareholder advances to a corporation are often reported as debt, when they more closely resemble equity.

* Numerous factors have been used by the courts to evaluate debt-versus-equity status, and the volume of cases demonstrates the ambiguity often surrounding the issue.

* The risk of reclassification can be greatly reduced or avoided, by using planning techniques that consider the factors and how they are evaluated.

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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 debt-versus-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 (1) All were withdrawn and have not been reissued.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 200205031 (2) (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 which they are evaluated. Some of them are subject to control prior to issuing the debt obligation; others must be monitored after the debt is issued. They are discussed below in three phases of planning: developing the instrument, monitoring corporate attributes and taking follow-up actions.

The Instrument

The underlying principle applied by the courts in debt-equity cases is that the transaction's economic substance, not its form, will be the controlling indicator of appropriate classification. An instrument's label is not always sufficient evidence of substance, but has been a decisive factor in determining the parties' intent. Even in the presence of other adverse circumstances, a well-written debenture has withstood an IRS challenge, as in Gloucester Ice & Cold Storage, (3) in which the First Circuit observed regarding debentures held by shareholders--"their classification depends upon an analysis of their provisions, not upon who owns them ... the bonds speak for themselves."

Terms

The instrument's terms assume importance in a shareholder loan, because the transaction is not at arm's-length and documentation clarifies the parties' intent for outsiders. A written document containing an unconditional promise to pay, a specific time for repayment, a specific principal sum and a fixed, reasonable rate of interest are required by both Sec. 385 and FSA 2002. This is the type of formal documentation an outside creditor would demand as evidence of a legally enforceable debt.

One of the major differences between debt and equity is the open-ended commitment of funds by capital investors, in contrast with the expectation of definite repayment by creditors. In general, outside creditors would not agree to the absence of a maturity date or demand feature when advancing funds. Thus, the absence of a fixed maturity date has been held to indicate equity. (4)

Another important requirement is that the note call for interest. A reasonable interest rate can be determined by comparing the rate offered by outside creditors. An excessively high rate may be interpreted as a constructive dividend, but a higher rate on shareholder debt without collateral has been justified when outside creditors held collateralized loans at a lower interest rate. (5)

The instrument must give the right to enforce payment; it will not be recognized as debt if there is a failure to create a binding obligation. (6) To be equivalent to outside debt, the document should provide the right to enforce payment without contingencies. (7) The requirement that the note contain a specific sum of money to be repaid indicates that advances on open account are vulnerable to a Service challenge.

The formality of a written promissory note in most cases is imperative, as evidenced in Roth Steel Tube, (8) in which both the shareholder and the corporation recorded advances as loans in their accounting records, but the absence of properly executed debt instruments was interpreted by the Sixth Circuit as an indication of capital contributions. The terms must be supported by the transaction's substance. In Jensen, (9) shareholders had documented their advances in promissory notes, but the notes were not issued contemporaneously with the loans and did not match the amounts advanced, resulting in adverse treatment by the court. On rare occasions, the absence of a written promissory note can be overcome by other documentation, such as a resolution in the corporate minutes that confirms the parties' intent to create debt and the terms thereof. (10)

It is certainly advisable for a promissory note to qualify as debt under state law, but this will not guarantee that it will also qualify for Federal tax purposes. The factors applied in the Federal tax context are substantially broader than those typically applied by the states. In one case, the fact that a shareholder won a judgment against the debtor corporation in state court was insufficient evidence to consider the advance as debt for Federal tax purposes. (11)

Subordination

* A well-documented instrument must be based on terms that simulate an arm's-length transaction. One of the factors identified in both FSA 2002 and Sec. 385 is whether there is subordination to other debt of the corporation. If the terms subordinate a shareholder's debt to that of outside creditors, the transaction begins to resemble equity. Subordination may be explicit in the terms of the instrument or may be implied by the actions of the parties involved.

The express subordination of shareholder notes to all outstanding creditors is clearly an adverse factor to debt classification, whether for-realized in the writing of the instrument or in the corporate minutes. In some cases, subordination to only one outside creditor has overcome the negative effect. (12) This was not true, however, in Universal Racquetball, (13) in which shareholder loans were subordinated to only one outstanding debt, but included all future obligations to that creditor. The factor of subordination has been overlooked when it exists to meet outside regulatory requirements, as in the case of Jones, (14) an insurance company, in which subordination was "superimposed ... by state law ... to protect the policyholders."

In Lantz, (15) despite the fact that shareholder notes were subordinated to meet standard requirements of "bank lending," it was viewed as a negative factor by the court, due to the lack of repayments, etc., on the notes. The subordination factor has been considered "unimportant" when there are no other substantial creditors. (16)

Subordination may be more subtly observed in actions taken by the parties. For example, it has been implied when shareholders did not attempt to obtain a security interest for advances made to a corporation that suffered recurrent losses and for which outside creditors required a security interest. (17) The absence of a shareholder's claim on a bankruptcy petition has also been interpreted as implied subordination. (18) The most common form of implied subordination is a shareholder's failure to demand repayment of advances while repayment continues to outside creditors. In Fries, (19) the Tax Court referred to the failure to enforce repayment as "de facto" subordination. Numerous cases have relied on the repayment to shareholders (or lack thereof) to evaluate the subordination factor. (20)

Proper development of the debt instrument will eliminate the problem of documented subordination. More in-depth tax planning will be required, however, to guard against subsequent actions on the part of shareholders that result in implied subordination of the debt interest to that of outside creditors.

Convertibility

Sec. 385(b)(4) clearly identifies the question of "whether there is convertibility into the stock of the corporation" as a pertinent issue in clarifying debt or equity. If an instrument is convertible into the corporation's stock (whether at the discretion of the holder or the issuer), it is more likely to be classified as equity. The conversion option may be explicit in the instrument's terms or may be implied when the corporate issuer has the discretion to repay a debt instrument by the use of its own stock. In Rev. Rul. 86-119, (21) debt classification was permitted when the holder could choose repayment in cash or stock, but the IRS noted that terms requiring the holder to accept payment in stock, or otherwise restricting the right to payment in cash, will result in the instrument being classified as equity.

Other Factors

Among other factors identified in FSA 2002 is "an increased participation in management as a result of the advance." When this factor is noted by the courts, it is usually treated as neutral or unimportant, because most debt-equity cases involve shareholders in closely held entities who already exercise substantial or complete control over company affairs. If the obligation's terms were to gram increased management authority or voting rights to the holder, this would obviously have an adverse effect on any argument favoring debt.

A final factor to be considered in establishing the terms of the instrument is the source of repayment. Often, the courts look for security, collateral or the presence of a sinking fund. The absence of collateral invites closer scrutiny as to the expectation of repayment. When repayment depends solely on the corporation's earnings and profits (E&P), the transaction has the appearance of equity. (22) This is particularly true if the corporation experiences continued losses or cashflow problems during the loan term or if the repayment of an advance would obviously impair the corporation's capital assets. In at least one case, the taxpayer did not have sufficient cashflow to repay shareholder loans, but the court noted that the assets had sufficiently increased in value to repay all outstanding debt (including that held by shareholders); this was viewed as an adequate source of repayment. (23)

On occasion, it has been acceptable to have implied collateral, such as in Est. of Mixon, (24) when shareholders temporarily advanced funds while the corporation awaited collection of a large receivable that would provide the funds for repayment. A similar view was taken in Hardman, (25) when repayment was to come from the sale of a parcel of land (rather than from the company's general E&P). In protecting the status of shareholder debt, it is prudent to include security or collateral in the instrument's terms and to avoid including any contingencies as to repayment.

Corporate Attributes

Several corporate attributes are significant in the debt-equity question. Certain financial measures--such as the debt-equity ratio--can be an important indication of whether similar financing could have been obtained from outside creditors. Other attributes, such as pro-rata holding of stock and debt by shareholders, or the manner in which the advance was recorded in the corporation's books, are signals of the parties' intent. The emphasis placed on these attributes by all sources of authority would suggest that protecting the classification of shareholder debt requires close monitoring of the debt-equity ratio, the proportion of shareholder debt relative to stockholdings and the classification in the issuer's accounting records.

Debt-Equity Ratio

Various indicators have been offered as evidence of the financial condition of the issuer, but "the ratio of debt to equity in the corporation" is the only one proposed in Sec. 385(b)(3). FSA 2002 refers to this factor as the "thinness of capital structure in relation to debt"; the Supreme Court has observed that "extreme situations such as nominal stock investments and an obviously excessive debt structure" must be considered when differentiating stock and debt. (26) The primary tool used to identify "thin capitalization" is the ratio of outstanding liabilities to shareholders' equity.

The debt-equity ratio is an objective, quantitative measure of the financial risk that an outside creditor would evaluate. It is used in most cases to evaluate the likelihood of a corporation obtaining similar financing from an outside lender. Two pointed questions have evolved from these cases--what is an acceptable ratio and how is it calculated?

The problem with evaluating the debt-equity ratio in this context is the variation in ratios found acceptable by the courts. Although frequently considered as a factor, no clear benchmark has evolved. Regs. Sec. 1.385-6(f)(3) of the withdrawn regulations contained a safe harbor that cited a debt-equity ratio not exceeding 10:1 (3:1 for the "inside ratio" defined below).

While there is no settled rule regarding a specific range, acceptable debt-equity ratios in recent cases have varied from 1.36:1 (in Bowater (27)) to 6.4:1 (in Nachman (28)). Excessive ratios have typically been fatal to a finding of debt. (29) A high ratio may be accepted, however, if a rational explanation is offered. For example, in Baker Commodities, (30) a ratio of 692:1 was surmounted by substantial cashflow and earning power sufficient to overcome the risk that a high ratio normally implies. In other cases, a high ratio has been justified by the nature of the business (31) or the fact that there was adequate capital for the venture's intended purpose. (32) Such findings are rare and clearly occur because the negative effect of a high ratio was overcome by other positive factors.

Subsequent trends: The trend of the debt-equity ratio is sometimes an adequate indication of financial condition. Delta Plastics Inc. (33) had a ratio of 26:1 at the time loans were advanced by its shareholders. Over the next three years, it declined to 4:1; the Tax Court accepted this decline as a signal of adequate capitalization. A trend in the opposite direction was damaging in Tyler, (34) when an increase from 7:1 to approximately 10:1, due to shareholder advances, was an adverse factor. Such a trend was also deemed very strong evidence against debt in Henderson, (35) when "the debt equity ratio was high to start with ... [and] the parties understood it would go higher." The negative effect in this case appeared to be exacerbated by a lack of evidence from the taxpayer (such as financial statements or balance sheets) to permit calculation of the ratio. (36)

Calculation: There are also inconsistencies among the courts as to the proper calculation of the debt-equity ratio. For example, in Bauer, (37) the Tax Court had assigned a ratio of 92:1 by comparing the current ending balance of shareholder debt with their initial capital contributions. On appeal, the Ninth Circuit corrected the ratio to 3.6:1, by including the balance of retained earnings in shareholders' equity when making the calculation. It derived this computation from a Senate Report (38) statement that "the debt-equity ratio of the issuing corporation for purposes of this test generally is determined by comparing the corporation's total indebtedness with the excess of its money and other assets over that indebtedness." In another case, the Tax Court increased the taxpayer's ratio by including debts owed to unconsolidated subsidiaries and minority interests reported on their financial statements. (39)

Regs. Sec. 1.385-6(h) and (j) of the withdrawn regulations defined two calculations of the debt-equity ratio. The "outside ratio" compares the corporation's liabilities (excluding trade payables, accrued expenses, taxes and similar items) to stockholders' equity (the excess of adjusted basis of assets over all liabilities). The "inside ratio" relies on the same calculation, but excludes liabilities to independent contractors. The outside ratio is used predominantly by the courts. (40) The rationale offered for this by the Tenth Circuit is that "the outside ratio is more relevant because it is the ratio a prospective creditor would have considered when deciding whether to advance funds." (41) Both the inside and outside ratios are determined using financial data for the end of the tax year in which the debt instrument was issued.

Some controversy exists regarding the use of book value or fair market value (FMV) in calculating the ratio. Despite the fact that Prop. Regs. Sec. 1.385-6(h)(2)(i) required the ratio to be based on the adjusted basis of the assets, case law has generally relied on FMV, unless the specific circumstances make its use unrealistic or impossible. In Laidlaw Transportation, (42) the Tax Court relied on book value because the taxpayer's loan agreements were based on it. In Dillin, (43) the Fifth Circuit agreed with the lower court that the ratio should be based on FMV, rather than book value. However, in Brazoria Cty. Stewart Food Markets, (44) the Tax Court accepted the government's calculation based on book value because, although the taxpayer claimed a substantially higher value of assets, it provided no appraisal other than self-serving testimony.

When shareholder debt is issued, the debt-equity ratio and any subsequent trends should be closely monitored. Certain disputes regarding the ratio can be avoided by adequate documentation of financial records and independent appraisals of asset value. Good tax planning requires caution and attention to other decisive factors when issuing shareholder debt with a highly leveraged capital structure.

Proportional Holding of Stock and Debt

All pertinent sources of authority have noted the proportional holding of stock and debt to be detrimental in recognizing shareholder advances as debt. The Second Circuit offered an explanation for this concern in Gilbert, (45) by noting that proportional debtholding is most likely when the risk is high. "Such an agreement is readily understood ... where there is real danger that the money might be lost ... each stockholder ... can be assured that his percentage of the equity and control will remain in correspondence with his share of the risk." In that case, two equal shareholders had an agreement to keep the financing on a 50-50 basis--this was interpreted as a means of providing additional equity under the guise of debt.

In the Tax Court's view, the holdings of stock and debt must be sharply disproportionate to serve as evidence of debt. If the holdings are neither pro rata nor sharply disproportionate, this factor becomes neutral. (46) The Eighth Circuit viewed proportionality to be unimportant when advances were made by a sole shareholder. (47)

Classification by the Issuer

An obvious starting point for determining the parties' intent as to a shareholder's contribution of funds would be the balance-sheet classification by the corporation. Although this factor is frequently mentioned in legal opinions, it has not been elevated as a separate and distinct factor, except in the Code. For instruments issued after Oct. 24, 1992, Sec. 385(c) makes the issuer's classification of the instrument binding on the corporation and all holders (unless a holder discloses inconsistent treatment on its tax return). The classification is not binding on the ILLS, so it continues to have wide latitude in challenging shareholder debt.

Other negative factors may overwhelm the reported classification of shareholder debt, but if proper accounting entries are not present, the risk of reclassification is magnified. In Noble, (48) the Tax Court found no written evidence that the parties ever intended to create debt--no notes, bookkeeping entries or indication in corporate records. An attempt to recharacterize the advances with a delayed corporate resolution was ineffective, largely because of a lack of evidence from the accounting records.

In Notice 94-47, (49) the Service indicated that it will scrutinize situations in which instruments are classified as equity for nontax reasons (such as satisfying regulatory rules or financial accounting standards), but reported as debt for tax purposes. Other factors may counterbalance the corporation's accounting classification. For example, in Est. of Mixon, certain shareholder advances were made without formal documentation and reported in the capital section of the balance sheet (as required by banking regulations). A clear business purpose was demonstrated by the fact that the bank would have been closed by Federal and state authorities without the temporary liquidity provided by the advances. Other factors favoring debt were sufficient to overwhelm the negative effect of equity classification by the issuer.

Notice 94-47 does not imply that reporting instruments as equity for regulatory purposes will automatically defeat debt treatment for tax purposes. It does indicate, however, that this will be a part of the multifactor analysis that is typically applied in these situations. Consistent treatment on the financial statements and tax returns of all parties involved can provide strong evidence of debt. (50)

Follow-Up Actions

Documenting an obligation that is above reproach may not be sufficient if not supported by subsequent actions, such as using funds for a business purpose and repaying the obligation. Although it is not always fatal for a shareholder to subsequently make concessions in consideration of the corporation's financial health, it is advisable to exhibit the same behavior that would be expected from an outside creditor.

Use of Funds

A clear business purpose for advancing the funds can serve as a strong rebuttal to the tax-avoidance-motive argument typically argued by the ILLS. An advance is in the nature of equity if used to acquire core assets or provide initial working capital or start-up costs. After initial capital requirements are met, shareholder loans made to support continued operations will tend to be viewed as bona fide debt, unless it is clear that the initial equity investment was insufficient to meet basic operating costs. The advancement of funds in the wake of growth, as opposed to lack of profits, indicates that the basic capital investment is adequate and funds are simply needed to carry the day-to-day operations through periods of growth.

The use of funds to acquire inventory (51) or, in one case, to acquire a competitor company (52) has been sufficient evidence of a business purpose for a loan. In Jones and Mixon, other questionable factors were overlooked by a clear business purpose for advancing funds in the form of debt. It is generally not supportive of debt classification when funds are used to meet payments to outside creditors. (53) The obvious strategy is to tie the shareholder debt to a specific business need.

Repayment

In an arm's-length transaction, creditors expect to be repaid timely. The lack of repayment on a shareholder loan defeats the appearance of a debtor-creditor relationship and clearly weighs in favor of equity. In numerous cases, absent or delayed payments were interpreted as strong evidence that the parties did not intend to treat the advance as debt. (54) It is especially critical when outside creditors are receiving timely payments on their obligations. If payment is delayed due to the company's misfortunes, this only strengthens the characterization of equity.

In Nestle Holdings, (55) the Service provided certain ratios as evidence that the company did not have sufficient liquidity to satisfy the loans when they were issued; this evidence was disregarded by the court, because actual repayments had been made, which was better evidence of the corporation's ability to repay. The Tax Court captured the essence of this factor in Bowater, when it noted that there is no better evidence of the intention to repay a debt than actual repayment.

Conclusion

In the multifactor framework that is in standard use for distinguishing debt from equity, no one factor is likely to be determinative. It cannot be predicted how specific factors will be weighed by a court and it may not be possible to plan each one to support debt classification. However, good tax strategy will maximize the number of factors favoring debt. The knowledge of the factors and the methods used to evaluate them should foster optimal planning in protecting the debt classification of shareholder advances.

For more information about this article, contact Dr. Burilovich at [e-mail].

(1) TDs 7747 (12/31/80) and 7801 (1/5/82).

(2) Field Service Advisory 200205031 (2/1/02).

(3) Gloucester Ice & Cold Storage Co., 298 F2d 183 (1st Cir. 1962).

(4) Ambassador Apartments, Inc., 50 TC 236 (1968); and Kathryn Fuscaldo, 267 F Supp 2d 442 (ED PA 2001).

(5) Indmar Products Co., Inc., 444 F3d 771 (6th Cir. 2006); for a discussion, see Burke, Tax Clinic, "Debt vs. Equity: The Saga Continues," 37 The Tax Adviser 507 (September 2006).

(6) Benjamin D. Gilbert, 248 F2d 399 (2d Cir. 1957).

(7) Joseph L. Fischer, 441 FSupp 32 (ED PA 1977) ("absence of an unconditional fight to demand payment is practically conclusive that an advance is equity").

(8) Roth Steel Tube Co., 800 F2d 625 (6th Cir. 1986).

(9) Kent Jensen, 208 F3d 226 (10th Cir. 2000).

(10) Est. of Travis Mixon, 464 F2d 394 (5th Cir. 1972).

(11) Thomas M. Fries, TC Memo 1997-93.

(12) See Indmar Products Co., Inc., note 5 supra; Baker Commodities, Inc., 48 TC 374 (1967); and Scriptomatic, Inc., 555 F2d 364 (3d Cir. 1977).

(13) Universal Racquetball Rockville Centre Corp., TC Memo 1986-363; see also Thomas R. Suthertand, TC Memo 1991-619, and Joseph Nachman, TC Memo 1996-288, in which similar sets of facts yielded the same result.

(14) Alexander Jones, 659 F2d 618 (5th Cir. 1981); see Est. of Mixon, note 10 supra, for a discussion of the same issue.

(15) A.R. Lantz, 424 F2d 1330 (9th Cir. 1970).

(16) Midland Distributors, Inc., 481 F2d 730 (5th Cir. 1973).

(17) See Jensen, note 9 supra; Lantz, note 15 supra; and Roth Steel Tube Co., note 8 supra.

(18) See Fuscaldo, note 4 supra.

(19) Fries, note 11 supra.

(20) See Jean I. Tedford, TC Summ. Op. 2004-132; Flint Industries, Inc., TC Memo 2001-276; Ginsberg, 6th Cir., 8/18/93; Inductotherm Indus., Inc., TC Memo 1984-281; Victor I. Rosenburg, TC Memo 2000-108; and Simon W. Henderson, 375 F2d 36 (5th Cir. 1967).

(21) Rev. Rul. 86-119, 1986-2 CB 81.

(22) It is generally not problematic if debt is repaid from E&P. The problem arises when repayment is contingent on said E&P.

(23) See R-W Specialties, Inc., TC Memo 1981-697.

(24) Est. of Mixon, note 10 supra.

(25) Rudolph Hardman, 827 F2d 1409 (9th Cir. 1987).

(26) John Kelley Co., 326 US 521 (1946).

(27) Bowater, Inc., TC Memo 1995-164.

(28) Nachman, note 13 supra.

(29) See Brazoria Cry. Stewart Food Markets, Inc., TC Memo 2001-220 (a ratio of 1,000:1 and debt was reclassified); Roth Steel Tube Co., note 8 supra (a ratio of 300:1 was excessive).

(30) Baker Commodities, Inc., note 12 supra.

(31) See P.M. Finance Corp., 302 F2d 786 (3d Cir. 1962).

(32) See Jolana Bradshaw, 683 F2d 365 (Ct. C1. 1982).

(33) Delta Plastics Inc., TC Memo 2003-54.

(34) Jean C. Tyler, 414 F2d 844 (5th Cir. 1969).

(35) Henderson, note 20 supra.

(36) Despite the absence of an authoritative rule creating an acceptable benchmark for the ratio, it appears that it would be to the taxpayer's benefit to provide a reason able argument as to what an acceptable range would be. In Universal Racquetball Rockville Centre Corp., note 13 supra, the court took a negative view of the absence of information from the taxpayer as to the proper range.

(37) Phillip E. Bauer, 748 F2d 1365 (9th Cir. 1984).

(38) S Rep't No. 91-552, 91st Cong., 1st Sess. (1969), at 1963-3 CB 513.

(39) See Bowater, note 27 supra.

(40) See Ginsberg, note 20 supra ('authorities uniformly use the 'outside ratio'").

(41) Jensen, note 9 supra. In this case, the court could not calculate the outside ratio because the taxpayer had failed to furnish financial statements or balance sheets as evidence.

(42) Laidlaw Transportation, Inc., TC Memo 1998-232.

(43) John W. Dillin, 433 F2d 1097 (5th Cir. 1970), aff'g DC FL, 4/2/69.

(44) Brazoria Cry. Stewart Food Markets, Inc., note 29 supra; see also Tedford, note 20 supra.

(45) Gilbert, note 6 supra.

(46) See Nachman, note 13 supra.

(47) See J.S. Biritz Construction Co., 387 F2d 451 (8th Cir. 1967).

(48) Rodney Noble, TC Summ. Op. 2002-68.

(49) Notice 94-47, 1994-1 CB 357.

(50) See Nachman, note 13 supra.

(51) In Biritz, note 47 supra, the shareholder sold a parcel of land held as inventory by the corporation in exchange for a note deemed to be valid debt by the court.

(52) Gloucester Ice & Cold Storage Co., note 3 supra.

(53) This was the case in Flint Industries, Inc., note 20 supra, and American Offshore, Inc., 97 TC 579 (1991).

(54) Examples include Ginsberg, note 20 supra; Slappey Drive Industrial Park, 561 F2d 572 (5th Cir. 1977); Alterman Foods, Inc., 505 F2d 873 (5th Cir. 1974); American Offshore, Inc., note 53 supra; Dixie Dairies Corp., 74 TC 495 (1980), and the cases cited therein.

(55) Nestle Holdings Inc., TC Memo 1995-441.

Linda Burilovich, Ph.D., CPA 

Professor

Department of Accounting

Eastern Michigan University 

Ypsilanti, MI

Exhibit: Factors that distinguish debt from equity

Sec. 385(b) and (c) factors

1. Whether there is n written unconditional promise
to pay on demand or on a specified date a sum
certain in money in return for an adequate consideration
in money or money's worth, and to pay
a fixed rate of interest.

2. Whether there is subordination to or preference
over any debt of the corporation.

3. Debt-to-equity ratio.

4. Whether there is convertibility into the corporation's
stock.

5. The relationship between holdings of stock in
the corporation and holdings of the interest in
question.

6. The characterization (as of the time of issuance)
by the issuer as to whether an interest in a corporation
is stock or debt shall be binding on such
issuer and on all holders of such interest (but shall
not be binding on the IRS).

FSA 200205031 factors

1. The name and presence of a written agreement
demonstrating debt.

2. The presence of a fixed maturity date.

3. The source of payments (e.g., whether there is
anticipated cashflow to cover payments).

4. The right to enforce payments.

5. Increased participation in management as the
result of the advance.

6. Subordination.

7. Thinness of capital structure in relation to debt.

8. Identity of interest between creditor and stockholder.

9. The source of interest payments (e.g., from
earnings).

10. The corporation's ability to obtain credit from
outside sources.

11. The use of funds for capital assets or risk
involved in making the advances.

12. Failure of debtor to repay.