Debt vs. Equity: Form & Substance Matter | Farrell Fritz, P.C.

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Some lessons need to be repeated until learned. It’s a basic rule of life. Don’t tug on Superman’s cape; don’t spit into the wind; don’t pull the mask off that old Lone Ranger; and if you are going to make a loan, give it the indicia of a loan and treat it as a loan.

The last of these lessons appears to be an especially difficult one for many owners of closely held businesses, at least based upon the steady flow of Tax Court cases in which the principal issue for decision is whether an owner’s transfer of funds to his business is a loan or a capital contribution.

The resolution of this question can have significant tax and economic consequences, as was illustrated by a recent decision.

Corp had an unusual capital structure. It had about 70 common shareholders, including key employees and some of Taxpayer’s family members, but common stock formed a very small portion of its capital structure. Indeed, although Taxpayer was Corp’s driving force, he owned no common stock. Corp’s primary funding came in the form of cash advances from Taxpayer.

Over several years, Taxpayer made 39 separate cash advances to Corp totaling millions of dollars. For each advance, Corp executed a convertible promissory note, bearing market-rate interest that Corp paid when due.

Taxpayer subsequently advanced a few more millions, of which only a small portion was covered by promissory notes, Corp recorded all these advances as loans on its books, and it continued to accrue interest, though no interest on any of this purported indebtedness.

After a few years, the entirety of this purported indebtedness was converted to preferred stock (the “Conversion”), representing 78% of Corp’s capital structure.

Taxpayer then made additional cash advances to Corp which were Corp’s sole source of funding during this period. Taxpayer generally made these advances monthly or semi-monthly in amounts sufficient to cover Corp’s budgeted operating expenses for the ensuing period.

Corp executed no promissory notes for these advances and furnished no collateral. As before, it recorded these advances on its books as loans and accrued interest, but it never paid interest on any of this purported indebtedness. These advances, coupled with Taxpayer’s preferred stock, constituted roughly 92% of Corp’s capital structure.

Corp incurred substantial losses during most years of its existence. This fact, coupled with Corp’s inability to attract other investors or joint venture suitors, caused Taxpayer to question the collectability of his advances. He obtained an independent evaluation of Corp’s financial condition, and was informed that Corp’s condition was precarious: Its revenue was 98% below target, and it had massive NOLs. Without Taxpayer’s continued cash infusions, he was told, the company would have to fold.

Taxpayer discussed with his accountant the possibility of claiming a bad debt loss deduction for some or all of his advances. Taxpayer took the position that all of his advances were debt and that the advances should be written off individually under a “first-in, first-out” approach.

Taxpayer’s attorney prepared a promissory note to consolidate the still-outstanding advances that Taxpayer did not plan to write off. While these documents were being prepared, Taxpayer made additional monthly advances to Corp. Taxpayer and Corp executed a debt consolidation , a consolidated promissory note, and a certificate of debt forgiveness, all of which were backdated to a date after the Conversion.

Corp continued to operate with Taxpayer continuing to advance millions which, again, were not evidenced by promissory notes.

Taxpayer filed his Federal income tax return on which he reported a business bad debt loss reflecting the write-down of his advances to Corp. According to Taxpayer, this loss corresponded to advances he had made after the Conversion. Taxpayer claimed this loss as a deduction against ordinary income.

The IRS disallowed the business bad debt deduction, and issued a notice of deficiency. Taxpayer petitioned the Tax Court.

The Code allows as an ordinary loss deduction for any “bona fide” business debt that became worthless within the taxable year. A business debt is “a debt created or acquired in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.” To be eligible to deduct a business bad debt, an individual taxpayer must show that he was engaged in a trade or business, and that the debt was proximately related to that trade or business.

A bona fide debt is one that arises from “a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case, including the purported creditor’s reasonable expectation that the amount will be repaid.

Advances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution. In general, advances made to an insolvent debtor are not debts for tax purposes, but are characterized as capital contributions.

The principal issue for decision was whether Taxpayer’s advances to Corp constituted debt or equity.

Taxpayer asserted that all of his advances to Corp constituted bona fide debt, whereas the IRS contended that Taxpayer made capital investments in his capacity as an investor. In determining whether an advance of funds constitutes bona fide debt, the Court stated, “economic reality provides the touchstone.”

The Court began by noting that, if an outside lender would not have lent funds to the corporation on the same terms as did the insider, an inference arises that the advance was a not a bona fide loan, even if “all the formal indicia of an obligation were meticulously made to appear.”

In general, the focus of the debt-vs.-equity inquiry is whether the taxpayer intended to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with creating a debtor-creditor relationship. The key to this determination is generally the taxpayer’s actual intent.

The Court identified the following nonexclusive factors to examine in determining whether an advance of funds gives rise to bona fide debt as opposed to an equity investment:

Labels on the Documents

If a corporation issues a debt instrument, such as a promissory note, that labeling supports the debt characterization.

Corp issued promissory notes for some of the cash advances Taxpayer made before the Conversion, those notes were converted to preferred stock and were not before the Court. The amount that was before the Court was advanced after the Conversion, and Corp did not issue a single promissory note to cover any of those advances. Rather, Taxpayer advanced cash on open account.

It was only in connection with the write-down that Corp issued Taxpayer to consolidate the portion of his advances that he chose not to write off, backdated to December 31, 2009. The Court found that this document was a self-serving document created in connection with Taxpayer’s year-end tax planning.

Fixed Maturity Date

A fixed maturity date is indicative of an obligation to repay, which supports characterizing an advance of funds as debt. Conversely, the absence of a fixed maturity date indicates that repayment depends on the borrower’s success, which in turn supports characterization as equity.

Because Corp issued no promissory notes for any of the advances at issue, there was of necessity no fixed maturity date.

Source of Payments

Where repayments depend on future corporate success, an equity investment may be indicated. And where prospects for repayment are questionable because of persistent corporate losses, an equity investment may be indicated.

Corp had substantial losses, its expenses vastly exceeded its revenue for all relevant years, and no payments of principal or interest has been made on Taxpayer’s still-outstanding advances. Corp was kept afloat only because Taxpayer continued to provide regular cash infusions keyed to Corp’s expected cash needs for the ensuing period. Thus, the most likely source of repayment of Taxpayer’s advances would be further cash infusions from Taxpayer himself.

Taxpayer testified that he hoped to secure ultimate repayment upon sale of Corp to a third party or a third-party investment in Corp. But this, the Court countered, is the hope entertained by the most speculative types of equity investors. Taxpayer was a “classic capital investor hoping to make a profit, not a creditor expecting to be repaid regardless of the company’s success or failure.”

Right to Enforce Payment of Principal and Interest

A definite obligation to repay, backed by the lender’s rights to enforce payment, supports a debt characterization. A lack of security for repayment may support equity characterization.

Although Taxpayer’s advances were shown as loans on Corp’s books, there was no written evidence of indebtedness fixing Corp’s obligation to repay at any particular time. None of Taxpayer’s advances was secured by any collateral. And even if Taxpayer were thought to have a “right to enforce repayment,” that right was nugatory because his continued cash infusions were the only thing keeping Corp afloat. Had he enforced repayment, he would simply have had to make a larger capital infusion the following month.

Participation in Management

Increased management rights, in the form of greater voting rights or a larger share of the company’s equity, support equity characterization.

Although Taxpayer had de facto control, he literally owned no common stock. But through his cash advances and preferred stock he held about 92% of Corp’s capital. Taxpayer contended that none of his advances gave him increased voting rights or a larger equity share. This was literally true, but it meant little because he already had complete control of the company by virtue of his status as its sole funder.

Status Relative to Regular Creditors

If Taxpayer had subordinated his right to repayment to that of other creditors, that would have supported an equity characterization.

However, Taxpayer was the only supplier of cash to Corp, which borrowed no money from banks and had no “regular creditors.” Taxpayer had, in absolute terms, none of the rights that a “regular creditor” would have; there was no promissory note, no maturity date, no collateral, no protective covenant, no personal guaranty, and no payment of interest. No “regular creditor” would have lent funds to a loss-ridden company like Corp on such terms.

Parties’ Intent

The Court examined whether Taxpayer and Corp intended the advance to be debt or equity. The aim is to determine whether the taxpayer intended to create a “definite obligation, repayable in any event.”

Taxpayer’s actions suggested that he intended the advances to be equity. He did not execute promissory notes for any of the advances at issue. He received no interest on his advances and made no effort to collect interest or enforce repayment of principal. Although Corp recorded the advances as loans and accrued interest on them, Taxpayer’s control over the company gave him ultimate discretion to decide whether and how repayment would be made. In fact, he expected to be repaid, as a venture capitalist typically expects to be repaid, upon sale of Corp to a third party or a third-party investment in Corp.

Inadequate Capitalization

A company’s capitalization is relevant to determining the level of risk associated with repayment. Advances to a business may be characterized as equity if the business is so thinly capitalized as to make repayment unlikely.

Taxpayer urged that, after the Conversion, the bulk of Corp’s capital structure consisted of preferred stock. He accordingly insisted that Corp was adequately capitalized at the time he made later advances.

The Court disagreed with Taxpayer’s assessment of the situation, observing that he made dozens of cash advances totaling many millions of dollars, and did not receive promissory notes until he decided to write off a portion of the purported debt.

Moreover, the Court continued, while Corp’s capitalization may have been adequate, that fact was not compelling. Normally, a large “equity cushion” is important to creditors because it affords them protection if the company encounters financial stress: The creditors will not be at risk unless the common and preferred shareholders are first wiped out. But because Taxpayer himself supplied almost 100% of Corp’s “equity cushion,” he would not derive much comfort from the latter prospect.

Identity of Interest between Creditor and Sole Shareholder

Taxpayer was not Corp’s sole shareholder, but he controlled the company and during the relevant period owned between most of Corp’s capital structure. There was thus a considerable identity of interest between Taxpayer in his capacities as owner and alleged lender. Under these circumstances, there was not a “disproportionate ratio between * * * [the] stockholder’s ownership percentage and the corporation’s debt to that stockholder.”

Payment of Interest

If no interest is paid, that fact supports equity characterization. Corp made no interest payments on any of the advances that Taxpayer made after the Conversion.

Ability to Obtain Loans From Outside Lending Institutions

Evidence that the business could not have obtained similar funding from outside sources supports characterization of an insider’s advances as equity. Although lenders in related-party contexts may offer more flexible terms than could be obtained from a bank, the primary inquiry is whether the terms of the purported debt were a “patent distortion of what would normally have been available” to the debtor in an arm’s-length transaction.

The evidence was clear that no third party operating at arm’s length would have lent millions to Corp without insisting (at a minimum) on promissory notes, regular interest payments, collateral to secure the advances, and a personal guaranty from Taxpayer. Especially is that so where the purported debtor was losing millions a year and could not fund its operations without Taxpayer’s monthly cash infusions.

Corp’s financial condition was extremely precarious in every year since its inception. The IRS determined that Corp had an extremely high risk of bankruptcy and that, without Taxpayer’s continued advances, it would surely have ceased operations. Under these circumstances, no third-party lender would have lent to Corp on the terms Taxpayer did.

In addition, Taxpayer continued to advance funds to Corp even after he concluded that its financial condition was dire enough to justify writing off some of his advances. An unrelated lender would not have acted in this manner.

After evaluating these factors as a whole, the Court found that Taxpayer’s advances were equity investments and not debt. Thus, it disallowed the Taxpayer’s business bad debt deduction.

The proper characterization of a transfer of funds is more than a metaphysical exercise enjoyed by tax professionals. It has real economic consequences. In the Taxpayer’s case, it meant the loss of a deduction against ordinary income. Whether out of ignorance, laziness, or negligence, many business owners continue to act somewhat cavalierly toward the characterization and tax treatment of fund transfers to their business.

This behavior begs the question: “Why?” Why, indeed, when the owner can dictate the result by following a simple lesson: a promissory note, consistent bookkeeping, accrual and regular payment of interest at the AFR. C’mon guys.


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