IRS Wins Debt vs. Equity Case

A frequent area of dispute between taxpayers and the IRS is whether an indebtedness obligation should be treated as debt, or an equity investment, for income tax purposes. Taxpayers often seek debt treatment to obtain interest deductions, defer gain to a seller, or avoid gift treatment. Sometimes the underlying transaction is a straight loan - other times it involves a financed purchased of property.

The latter is what occurred in the subject case - a U.S. corporation purchased partnership units from a foreign corporation for a debt obligation. The debt was helpful since it provided an interest deduction to the U.S. obligor, deferred gain on the sale to the selling foreign corporation, and no taxable interest income to the foreign corporation obligee per qualification of the debt as tax-exempt portfolio interest debt.

There were factual aspects of the transaction that prompted the IRS to assert that the debt obligation was not debt, but an equity investment by the foreign corporation in the U.S. corporation.

In distinguishing debt from equity, the ultimate question is whether there was a genuine intention to create a debt, a reasonable expectation of repayment, and a finding that the intent comports with the economic reality of creating a debtor-creditor relationship.

There are a number of factors that courts will examine, including: (1) the names given to the certificate evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of the funds used to pay interest and repay the creditor; (4) the right to enforce the payment of principal and interest; (5) the extent of a creditor's participation in management; (6) the status of the advance in relation to other corporate creditors; (7) the intent of the parties; (8) thinness of capital structure in relation to the debt; (9) identity of interest between creditor and stockholder; (10) the debtor's ability to obtain loans from outside lending institutions; (11) the extent to which the advance was used to acquire capital assets; and (12) the failure of the debtor to pay on the due date or to seek a postponement.

The court sided with the IRS and found the debt was actually an equity investment. Some of the key aspects that supported the finding included:

a. No real negotiation of the terms of the debt between the parties;

b. The purported borrower obtains significant rights over debtor operations such that it effectively managed the debtor;

c. The principal source of repayment of the debt was the purchased asset;

d. There was no down payment;

e. The notes were not paid timely, with extensions to pay being granted in lieu of the lender declaring a default. A reduction in the interest rate was also granted;

f. On the sale transaction, an independent valuation of the purchase price/value was not undertaken - the taxpayers instead adopted the suggestion for a price of the tax advisor;

g. Suggestions of non-arms length aspects of the transactions

Now some of these factors are often found in lending transactions. I would speculate that it was the structured nature of the transaction by a tax advisor so as to obtain tax deductions, no U.S. income tax on the interest payments, branch profits tax problems of the selling entity, and the ability of the U.S. corporation to benefit from an NOL in regard to income from the purchased partnership interest, that may have swayed the court against the taxpayer. The appeals court itself noted this when it declared “[m]any cases demonstrate the difference between arranging a contemplated business transaction in a tax-advantaged manner, which is legitimate, and entering into a prearranged transaction designed solely to use preserved NOLs and create a tax benefit, which is not.”

Not only did the court find against the existence of a debt obligation, but it further found that the debtor did not have reasonable cause for its position and thus was subject to substantial understatement penalty on the interest deductions it took.

Note that related party sales and debt are often undertaken for estate planning purposes. The foregoing concepts could be applied by the IRS to treat such arrangements as taxable gifts in lieu of debt transactions.

Proposed 2016 regulations under Code §385 were not applicable here, but could impact similar fact patterns in the future if the regulations are adopted. Under those proposed regulations, debt between related corporations will not be treated as debt if not in writing, and a written analysis of ability to repay is not undertaken, all within a short time of period of the establishment of the debt. However, even if one clears the hurdle of these potential new requirements, the IRS will still be able to challenge the arrangement under the above factor analysis.

A cautionary tale.

American Metallurgical Coal Co., TC Memo 2016-139

Treasury Removes a Reporting Trap for Section 83(b) Elections

Taxpayers who receive property as payment for performing services are generally taxable on the value of the property received in the year of receipt. Section 83 may allow such taxation to be deferred when the property received is subject to a substantial risk of forfeiture (e.g., an employee is issued stock, but will forfeit it if he quits or is fired) until the risk of forfeiture is removed.

Such a delay can hurt the employee, since the value of the property may increase before the risk of forfeiture is removed – the employee is required to include the value of property in income based on the value at the time such forfeiture risk goes away.

Section 83(b) provides relief to the employee – the employee can file an election with the IRS within 30 days of receiving the property to include it in income in the year of receipt even if there is a substantial risk of forfeiture. An employee may want to do this if he or she believes the current value is low, and the value later when the risk of forfeiture disappears may be materially higher.

To make a valid election, the regulations also require that a copy of the election be filed with the employee’s income tax return for the year of the election. This is a trap for an employee who forgets to do this.

This last requirement to file a copy with the tax return has now been removed in newly adopted Treas. Regs. § 1.83-2(c). To make the election, all that is needed now is the filing of the election within 30 days of receiving the property.

This change does not appear to be motivated by a desire to remove a trap for taxpayers – instead, it is in acknowledgment of the difficulty of filing a copy of an election if the tax return is filed electronically.

T.D. 9779, 07/25/2016, Reg. § 1.83-2

Save the Date – September 28, 2016!

If you are in South Florida, and are interested hearing Jonathan Blattmachr present at the 3rd annual Palm Beach County Wealth & Estate Planning Seminar, click here to learn more and register (scroll down to the bottom of the list on that page for “Individual” sign ups). Space is limited, so don’t delay!

Jonathan will be speaking on two topics - The Critical Importance of Significant Tax Free Returns and How to Achieve Them, and The New Regulations Under Section 2704(b). If those new regulations are not released by then, the alternate topic will be The Charitable Deduction for Estates and Trusts–Something You Need to Know Cold. The presentation is given at the Boca Raton campus of Florida Atlantic University in the late afternoon, and is followed by a cocktail reception.

It is not too late to sign up as a sponsor either – so if you would like to get your name or your business name placed prominently before 250 or so of the best and brightest attorneys, accountants, financial advisers, insurance agents, and others in the South Florida estate planning community, click here for what you received with each level of sponsorship, click here to sign up to be a sponsor, or send me an email at crubin@floridatax.com and I can help and answer any questions. Again, the sooner you sign up, the quicker we can get you added to the list of sponsors on the event website and on event mailings.

I hope to see many of you there on September 28!