Opinion ID: 2973623
Heading Depth: 3
Heading Rank: 3

Heading: Roth Steel Factors

Text: After discussing some, but not all, of the Roth Steel factors, the Tax Court concluded that the Rowes’ advances were equity contributions. Specifically, it found the following factors weighed in favor of equity: (i) Indmar did not pay any formal dividends (although this is not one of the Roth Steel factors); (ii) there was no fixed maturity date or obligation to repay; (iii) repayment came from corporate profits and would not be paid if there were not sufficient profits; (iv) advances were unsecured; (v) there was no sinking fund; and (vi) at the time advances were made, there was no unconditional and legal obligation to repay. The court found that several factors weighed in favor of debt: (i) Indmar reported the advances on its federal income tax returns as interest expenses; (ii) external financing was available; (iii) Indmar was adequately capitalized; (iv) the advances were not subordinated to all creditors; and (v) the Rowes did not make the advances in proportion to their respective equity holdings. The court concluded that the factors favoring equity “certainly outweigh” those favoring debt. Indmar, 2005 T.C.M. LEXIS 31, at . As explained below, we find that the Tax Court clearly erred in concluding that the advances were equity contributions rather than bona fide debt. The Tax Court failed to consider several Roth Steel factors. It also did not address in its analysis certain uncontroverted testimony and evidence upon which the parties stipulated. Consideration of all of the record evidence in this case leaves us “with the definite and firm conviction that a mistake has been committed.” Holmes, 184 F.3d at 543.
The first factor to which we look is whether or not a fixed rate of interest and fixed interest payments accompanied the advances. Roth Steel, 800 F.2d at 631. The absence of a fixed interest rate and regular payments indicates equity; conversely, the presence of both evidences debt. Id.; 7 Mertens Law of Fed. Income Tax’n § 26:28 (“A fixed interest rate is indicative of a deductible interest payment.”) (collecting cases). In its findings of fact, the Tax Court determined that the advances were made with a 10% annual return rate. The court also found that Indmar made regular monthly interest payments on all of the advances. The fixed rate of interest and regular interest payments indicate that the advances were bona fide debt. In its analysis, however, the Tax Court took a different view. Rather than analyzing these facts within the Roth Steel framework (i.e., as objective indicia of debt or equity), the Tax Court focused instead on why the Rowes made the advancements: it concluded that the Rowes No. 05-1573 Indmar Prods. Co. v. Comm’r Page 7 “characterized the cash transfers as debt because they wanted to receive a 10-percent return on their investment and minimize estate taxes.” Indmar, 2005 T.C.M. LEXIS 31, at . Yet, neither of these intentions is inconsistent with characterizing the advances as loans. For tax purposes, it is generally more important to focus on “what was done,” than “why it was done.” United States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1968). “In applying the law to the facts of this case, . . . it is ‘clear that the objective factors . . . are decisive in cases of this type.’” Raymond, 511 F.2d at 191 (quoting Austin Village, 432 F.2d at 745). It is largely unremarkable that the Rowes wanted to receive a return from their advances. Most, if not all, creditors (as well as equity investors) intend to profit from their investments. Bordo Prods. Co. v. United States, 476 F.2d 1312, 1322 (Ct. Cl. 1973). As long as the interest rate is in line with the risks involved, a healthy return on investment can evidence debt. Of course, “[e]xcessively high rates would . . . raise the possibility that a distribution of corporate profits was being disguised as debt. Were such the purpose of an exorbitant interest rate, the instrument involved would probably not qualify as debt in form.” Scriptomatic, Inc. v. United States, 555 F.2d 364, 370 n.7 (3d Cir. 1977) (citing William T. Plumb, Jr., The Fed. Income Tax Significance of Corporate Debt: A Critical Analysis & A Proposal, 26 Tax L. Rev. 369, 439-40 (1971)). The Tax Court found that the 10% rate exceeded the federal prime interest rate during most of the period at issue, as well as the rate charged by FTB on several of its loans to Indmar. The record indicates that the 10% rate was not an “exorbitant interest rate” under the circumstances. Indmar had a collateralized line of credit with FTB, which, similar to the stockholder advances, was available for short-term working capital. The rate charged by FTB for the line of credit ranged between 8%-9.5%, a rate not much below the fixed rate of 10% charged by the Rowes. The rate differential makes financial sense when considering the2 differences in security – the FTB line of credit was secured while the Rowes’ advances were not. As for the Rowes’ desire to minimize their estate taxes, this also offers little to the analysis. “Tax avoidance is entirely legal and legitimate. Any taxpayer ‘may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.’” Estate of Kluener v. Comm’r, 154 F.3d 630, 634 (6th Cir. 1998) (quoting Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (L. Hand, J.)). The desire to avoid or minimize taxes is not itself directly relevant to the question whether a purported loan is instead an equity investment. Rather, such a desire is only tangentially relevant, by acting as a flag to the Commissioner and courts to look closely at the transaction for any objective indicia of debt. Far from proving the Commissioner’s position, the existence and consistent payment of a fixed, reasonable interest rate strongly supports the inference that the advances were bona fide loans.
“The absence of notes or other instruments of indebtedness is a strong indication that the advances were capital contributions and not loans.” Roth Steel, 800 F.2d at 631. In its analysis, the Tax Court found that Indmar “failed to establish that, at the time the transfers were made, it had the 2 The government took pains during trial to show that Indmar could have received a lower interest rate from FTB than its stockholders. Had the 10% rate been exorbitant, this would have been a useful line of inquiry. Under the circumstances here, the rate was not exorbitant, and whether Indmar could have received a better rate through FTB is of no import. To show bona fide debt, a taxpayer does not need to prove that it received the financially optimal rate, just a commercially reasonable one. No. 05-1573 Indmar Prods. Co. v. Comm’r Page 8 requisite unconditional and legal obligation to repay the Rowes (e.g., 3the transfers were not documented).” Indmar, 2005 T.C.M. LEXIS 31, at  (emphasis added). The Tax Court focused on only half the story. For years 1987-1992, the Rowes did make advancements without executing any notes or other instruments. Beginning in 1993, and for all the tax years at issue in this case, the parties executed notes of loans and lines of credit covering all of the advances at issue, as the Tax Court noted in its findings of fact. Yet, in its analysis of the Roth Steel factors, the Tax Court was silent as to the subsequent execution of notes. After-the-fact consolidation of prior advances into a single note can indicate that the advances were debt rather than equity contributions. See, e.g., Dev. Corp. of Am. v. Comm’r, T.C.M. 1988-127, 1988 T.C.M. LEXIS 155, at . The Tax Court erred by focusing4 on the initial lack of documentation without addressing the subsequent history of executed notes.
“The absence of a fixed maturity date and a fixed obligation to repay indicates that the advances were capital contributions and not loans.” Roth Steel, 800 F.2d at 631. Based on the Rowes’ waivers, the Tax Court concluded that there was no fixed maturity date or fixed obligation to repay. While correct, we find that this factor carries little weight in the final analysis. The parties structured the advances as demand loans, which had ascertainable (although not fixed) maturity dates, controlled by the Rowes. Piedmont Minerals, 429 F.2d at 563 n.5 (“The absence of a fixed maturity date is a relevant consideration, but it is far from controlling. The maturity of a demand note is always determinable by its holder.”). Furthermore, the temporary waiver of payment does not convert debt into equity “since [the stockholders] still expected to be repaid.” AutoStyle Plastics, 269 F.3d at 751. Where advances are documented by demand notes with a fixed rate of interest and regular interest payments, the lack of a maturity date and schedule of payments does not strongly favor equity. To give any significant weight to this factor would create a virtual per se rule against the use of demand notes by stockholders, even though “[m]uch commercial debt is evidenced by demand notes.” Piedmont Minerals, 429 F.2d at 563 n.5; see also AutoStyle Plastics, 269 F.3d at 750 (cautioning against a “rigid” rule that the factor always indicates equity).
“An expectation of repayment solely from corporate earnings is not indicative of bona fide debt regardless of its reasonableness.” Roth Steel, 800 F.2d at 631 (emphasis added). Repayment can generally come from “only four possible sources . . .: (1) liquidation of assets, (2) profits from the business, (3) cash flow, and (4) refinancing with another lender.” Bordo Prods., 476 F.2d at 1326 (quoting Plumb, supra, at 526). The Tax Court found that the “source of repayments” factor favored equity. It relied upon Richard Rowe’s testimony that Indmar was expected to make a profit and that repayment “has to come from corporate profits or else the company couldn’t pay for it.” Indmar, 2005 T.C.M. LEXIS 31, at . The full colloquy from the testimony, however, is more equivocal: 3 The Tax Court did count in favor of debt the fact that Indmar consistently reported the payments as interest expense on its federal taxes. 4 The Tax Court was troubled by the treatment of the advances in the company’s records as both demand debt and long-term debt. While we share the Tax Court’s concerns, this was not the issue before the Tax Court or us on appeal. Importantly, regardless of whether it classified the payments as demand debt or long-term debt, the company at all times identified the advances as some form of debt. We leave it to the Tennessee authorities to determine whether Indmar owes any state taxes or penalties as a result of its reporting and accounting practices. No. 05-1573 Indmar Prods. Co. v. Comm’r Page 9 Q. . . . [A]t the time that you made these advances, were you anticipating that the repayment was going to come from corporate profits? A. Yes, sir. It has to come from corporate profits or else the company couldn’t pay for it. Unless it made profit – and I have always believed from the first day we started, that we were going to be profitable. Q. Was it your understanding and intent, at the time you made these advances, that if the company was not, in fact, profitable, you would not be repaid? A. I had no intentions of not being repaid, sir. Q. Why is that? A. I believe it’s me. It’s my personality. Q. Is that because you intended to make a profit? A. Yes, sir. There are at least two plausible ways to read this testimony. One can read it the way the Tax Court apparently did – Rowe’s testimony was, at best, contradictory: repayment must come from profits, but he had no intention of not being repaid, regardless of the company’s fortunes. Given the apparent contradiction, one should focus on the statement against Indmar’s interest: Rowe admitted that repayment of the advances “has to come from corporate profits or else the company couldn’t pay for it.” If repayment “has” to come from profits, then this would imply that repayment was tied to the company’s fortunes, suggesting the advances were equity contributions. Another way to read the testimony, however, is that Rowe, as a small businessman and unsecured creditor, believed that full repayment of all of Indmar’s debt required a thriving, successful business, which, ultimately, required profits. In other words, struggling companies near or at bankruptcy do not repay their debts, at least not dollar for dollar. Under this reading, his testimony is consistent with debt. In fact, we sounded a similar note in an earlier decision addressing the debt/equity issue: “One who makes a loan to a corporation also takes a risk, and while he may receive evidence of an obligation, payable in any event, often such obligation is never paid. . . . ‘All unsecured loans involve more or less risk.’” Byerlite, 286 F.2d at 292 (quoting Earle v. W.J. Jones & Son, Inc., 200 F.2d 846, 851 (9th Cir. 1952)). If there was no other evidence to support one view or the other, we could not say that the Tax Court’s reading was clearly erroneous. Credibility determinations are left to the fact finder, and our review on appeal is strictly limited. The “Tax Court ‘is not bound to accept testimony at face value even when it is uncontroverted if it is improbable, unreasonable or questionable.’” Lovell & Hart, Inc. v. Comm’r, 456 F.2d 145, 148 (6th Cir. 1972) (quoting Comm’r v. Smith, 285 F.2d 91, 96 (5th Cir. 1960)). On the other hand, the Tax Court cannot ignore relevant evidence in making its factual findings and any inferences from those findings. Here, there is undisputed testimony by Rowe and the FTB lending officer, corroborated by stipulated evidence in the record, that clearly weighs in favor of debt on this factor. Indmar repaid a significant portion of the unpaid advances – $650,000 – not from profits but by taking on additional debt from FTB. While the interest rate on the FTB loan was lower than 10%, Indmar had to secure the bank loan with inventory, accounts and general intangibles, equipment, and personal guarantees. Thus, Indmar repaid a significant portion of the unsecured stockholder advancements by taking on secured debt from a bank, rather than by taking the funds directly from earnings. This is important evidence that the parties had no expectation that Indmar would repay the advances No. 05-1573 Indmar Prods. Co. v. Comm’r Page 10 “solely” from earnings. The Tax Court did not discuss or even cite this evidence in its Roth Steel analysis. 5. The Extent to Which the Advances Were Used to Acquire Capital Assets Nor did the Tax Court address whether Indmar used the advances for working capital or capital expenditures. “Use of advances to meet the daily operating needs of the corporation, rather than to purchase capital assets, is indicative of bona fide indebtedness.” Roth Steel, 800 F.2d at 632. Richard Rowe testified that Indmar always went to a bank for funds to buy capital equipment. He also testified that all of the advances he made to Indmar were used for working capital, as opposed to capital equipment. This is uncontroverted testimony. The government points, however, to Rowe’s testimony that he advanced funds even when Indmar did not “need” the funds, and argues that this somehow cuts against his testimony that the advances were used as working capital. The government’s argument is unpersuasive. We do not find that Rowe’s testimony on this subject was “improbable, unreasonable or questionable,” especially in the absence of the Tax Court addressing this factor in its analysis.5 A review of Indmar’s financial statements shows that it used all of the funds it received in various ways, including working capital and capital equipment expenditures. Thus, Indmar used the advances it received from the Rowes, even if not immediately upon receipt – i.e., Indmar identified a “need” for the advances at some point. There is nothing specific in the record, including Indmar’s financial statements, that suggests the advances went to purchase capital equipment as opposed to being used for working capital. Accordingly, the government’s supposition does not counter Rowe’s testimony, and this factor squarely supports a finding of debt. 6. Sinking Fund “The failure to establish a sinking fund for repayment is evidence that the advances were capital contributions rather than loans.” Id. The Tax Court was correct to point out that the lack of a sinking fund favors equity. This factor does not, however, deserve significant weight under the circumstances. First, a sinking fund (as a type of reserve) is a form of security for debt, and the Tax Court also counted the general absence of security for the stockholder advances as favoring equity. Second, the presence or absence of a sinking fund is an important consideration when looking at advances made to highly leveraged firms. In that case, the risk of repayment will likely be high on any unsecured loans, so any commercially reasonable lender would require a sinking fund or some other form of security for repayment. Where a company has sound capitalization with outside creditors ready to loan it money (as here), there is less need for a sinking fund. See Bordo Prods., 476 F.2d at 1326. 7. The Remaining Roth Steel Factors On the remaining Roth Steel factors, the Tax Court determined that one favored equity (lack of security for the advances) and four favored debt (the company had sufficient external financing available to it; the company was adequately capitalized; the advances were not subordinated to all creditors; and the Rowes did not make the advances in proportion to their respective equity holdings). These findings are well-supported in the record. 5 As the Tax Court did not address this factor, it made no credibility determinations with respect to Richard Rowe’s testimony relating to the use of the advancements. At one point in its decision the Tax Court did find that Rowe’s testimony was “contradictory, inconsistent, and unconvincing” and that the parties “manipulated facts,” but this was in specific reference to its discussion about the inconsistent treatment of the advances as demand debt and long-term debt. See Indmar, 2005 T.C.M. LEXIS 31, at -13; see also supra note 4. No. 05-1573 Indmar Prods. Co. v. Comm’r Page 11 8. Failure to Pay Dividends The Tax Court included in its discussion of Roth Steel a factor not actually cited in that case – Indmar’s failure to pay dividends. In support, the Tax Court cited our decision in Jaques v. Commissioner. The relevance of Jaques to this case is questionable. That case involved the withdrawal of funds by a controlling stockholder from his closely-held corporation. The stockholder argued that the withdrawal itself was a loan. We rejected the argument, relying in part on the fact that the corporation had never issued a formal dividend, and thus the withdrawal could have been a disguised dividend. Jaques, 935 F.2d at 107-08. The situation here is the exact opposite – the stockholders were advancing money to the corporation (not from), and it is the nature of those advances that we must determine. Had the Rowes charged Indmar an exorbitant interest rate, the lack of any formal dividends might have been relevant to showing that the payments were not interest payments, but disguised dividends. As this was not the case, see supra Section II.C.1, we do not address further the relevance, if any, of the lack of dividend payments to the debt/equity question presented here.