Opinion ID: 2973623
Heading Depth: 3
Heading Rank: 1

Heading: Determining Whether Advance Is Debt or Equity

Text: As a general matter, the Commissioner’s determination of a deficiency is entitled to a presumption of correctness. It is the taxpayer’s burden to prove the determination to be incorrect or arbitrary. Ekman v. Comm’r, 184 F.3d 522, 524 (6th Cir. 1999). The basic question before us is whether the advances made to the company by the stockholders were loans or equity contributions. Under 26 U.S.C. § 163(a), a taxpayer may take a tax deduction for “all interest paid or accrued . . . on indebtedness.” There is no similar deduction for dividends paid on equity investments. Thus, if the advances were loans, the 10% payments made by Indmar to the Rowes were “interest” payments, and Indmar could deduct these payments. If, on the other hand, the advances were equity contributions, the 10% payments were constructive dividends, and thus were not deductible. Over the years, courts have grappled with this seemingly simple question in a wide array of legal and factual contexts. The distinction between debt and equity arises in other areas of federal tax law, see, e.g., Roth Steel Tube Co. v. Comm’r, 800 F.2d 625, 629-30 (6th Cir. 1986) (addressing the issue in the context of the deductibility of advances as bad debt under 26 U.S.C. § 166(a)(1)), as well as bankruptcy law, see, e.g., In re AutoStyle Plastics, Inc., 269 F.3d 726, 750 (6th Cir. 2001). The Second Circuit set out the “classic” definition of debt in Gilbert v. Commissioner: “an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof.” 248 F.2d 399, 402 (2d Cir. 1957). “While some variation from this formula is not fatal to the taxpayer’s effort to have the advance treated as a debt for tax purposes, . . . too great a variation will of course preclude such treatment.” Id. at 402-03. The question becomes, then, what is “too great a variation”? To determine whether an advance to a company is debt or equity, courts consider “whether the objective facts establish an intention to create an unconditional obligation to repay the advances.” Roth Steel, 800 F.2d at 630 (citing Raymond v. United States, 511 F.2d 185, 190 (6th Cir. 1975)). In doing so, courts look not only to the form of the transaction, but, more importantly, to its economic substance. See, e.g., Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968) (“The various factors . . . are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship.”); Byerlite Corp. v. Williams, 286 F.2d 285, 291 (6th Cir. 1960) (“In all cases, the prevailing consideration is that artifice must not be exalted over reality, whether to the advantage of the taxpayer, or to the government.”). The circuit courts have not settled on a single approach to the debt/equity question. We elucidated our approach in Roth Steel, setting out eleven non-exclusive factors for courts to consider: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of No. 05-1573 Indmar Prods. Co. v. Comm’r Page 5 outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. 800 F.2d at 630. No single factor is controlling; the weight to be given a factor (if any) necessarily depends on the particular circumstances of each case. Id.; see also Universal Castings Corp., 37 T.C. 107, 114 (1961) (“It is not enough when examining such a precedential checklist to test each item for its presence or absence, but it is necessary also to weigh each item.”), aff’d, 303 F.2d 620 (7th Cir. 1962). In essence, the more a stockholder advance resembles an arm’s-length transaction, the more likely it is to be treated as debt. AutoStyle Plastics, 269 F.3d at 750.