Circuit Court of Appeals Reverses Debt-Versus-Equity Issue
C. Barton and Clayton R. Sager
APRIL 2007 -
In Indmar Products, Co., Inc. v. Comm’r [444 F.3d
771 (6th Cir. 2006), rev’g 89 TCM 795 (2005)], the Sixth Circuit
Court of Appeals ruled that advances by a majority stockholder to
a corporation were debt rather than equity, so the corporation was
allowed to deduct the interest expense. The debt-versus-equity issue
also arises in bankruptcy cases and in the deduction of losses (ordinary
or capital) when the advances are not repaid. The Indmar Products
case illustrates the complexity of this issue and the broad latitude
the courts have in deciding it.
163(a) allows taxpayers to deduct interest paid or accrued on
indebtedness, but dividends paid on equity are not deductible.
Majority shareholders and the corporations they own are related
parties under IRC section 267(b)(2). The IRS and the courts examine
any advances between related parties with special scrutiny when
taxpayers claim the advances are loans.
an unqualified obligation to pay a sum certain with interest,
whether the debtor has income or losses. For the advances to be
considered debt, case law has established that the objective facts
of a taxpayer’s situation must indicate the intention to
create an unconditional obligation to repay the advances. Although
the courts consider both the form and the economic substance of
advances, the economic substance is more important. The more a
stockholder’s advance resembles a loan that an external
lender would make to the corporation, the more likely the advance
will be considered debt.
Products, following Roth Steel Tube v. Comm’r
[800 F2.d 625 (6th Cir. 1986)], the Sixth Circuit applied an 11-factor
test to distinguish between debt and equity. The presence of each
of the following 11 factors is considered evidence that the arrangement
- A fixed
rate of interest and interest payments
evidence of the debt, such as notes
- A fixed
maturity date and schedule of payments
- An expectation
that repayment not be solely from corporate earnings
the advances for working capital rather than to purchase capital
a sinking fund
security for the advances
- Not subordinating
the advances to all creditors
an adequately capitalized corporation
- Not making
the stockholders’ advances proportionate to their equity
- The corporation
has the ability to obtain sufficient outside financing.
No single factor is controlling, and the weight a court gives
each (if any) depends on the particular circumstances of each
of Indmar Products
and Donna Rowe each owned 37% of Indmar Products. From 1986 to
2000, Indmar Products’ sales increased from $5 million to
$45 million, and working capital increased from $471,386 to $3.8
million. During those years, Indmar Products paid no dividends.
From 1987 to 2000, the Rowes made unsecured cash advances to Indmar
Products. Total advance balances ranged from $634,000 to $1.7
million, and the balance on December 31, 2000, was $1,166,912.
Indmar Products paid interest to the Rowes monthly and deducted
the interest on its corporate tax return. The interest rate was
a fixed 10% per year. The IRS disallowed the interest expense
deductions for 1998–2000 and issued a deficiency of $123,735
in tax and $24,747 in penalties.
Indmar Products and Donna Rowe executed a written note for her
outstanding balance of $201,400. In 1995, Indmar Products and
Richard Rowe executed a written note for his outstanding balance
of $605,681. Both were demand notes, had no maturity date or repayment
schedule, were freely transferable, and specified an interest
rate of 10%. The parties executed similar notes for future advances.
the advances were to be repaid on demand, the Rowes excluded the
interest income on their Tennessee income tax return. (Tennessee
exempts interest income on notes that mature in six months or
less.) Indmar Products recorded the advances as long-term loans
on its financial statements, however, to avoid violating loan
agreements with First Tennessee Bank (FTB). To address this inconsistency,
from 1989 to 2000 the Rowes signed annual waivers agreeing to
forgo repayment of any of the advances for at least 12 months.
Indmar Products disclosed these waivers in footnotes to its financial
statements. Despite the waivers, the Rowes demanded and received
partial repayments of over $1 million in the 1990s.
banks sought to lend Indmar Products money at low interest rates
due to its profitability. From 1993 to 1997, FTB lent Indmar Products
$3.5 million, secured by various assets and the Rowes’ personal
guarantee. The loan agreements required that the advances from
the Rowes be subordinate to the FTB loan and that no repayments
of the advances be made while the FTB loans were outstanding.
Indmar Products made partial repayments to the Rowes in violation
of this requirement, and FTB knew of these violations.
Court ruled that the advances were equity, not debt. Indmar Products
could not deduct the interest expense, and was liable for the
penalties. The Tax Court emphasized three reasons for its ruling:
The 10% rate was above the prime rate; the Rowes and Indmar Products
manipulated the facts and violated loan agreements regarding the
current or long-term nature of the notes and the waivers; and
the advances were not arm’s-length transactions, due mainly
to the first two factors. In addition, the court repeatedly found
Richard Rowe’s testimony unconvincing.
In a well-researched
opinion, the Sixth Circuit ruled that the Tax Court committed
clear error because eight of the 11 factors supported debt and
two of the other factors deserved little weight, given the facts.
In addition, the Sixth Circuit pointed out that the Tax Court
did not consider several of the 11 factors and did not address
certain uncontroverted testimony and stipulated evidence.
the 11 factors, the Sixth Circuit ruled that the 10% interest
rate was commercially reasonable, which is the appropriate standard
to use. (An exorbitant interest rate could indicate a disguised
dividend.) The court also ruled that an after-the-fact consolidation
of prior advances into a single note can indicate debt. Sharing
the Tax Court’s concern about Indmar Products’ treatment
of the advances as both demand and long-term debt, the Sixth Circuit
pointed out that both are categories of debt, not equity.
a fixed maturity date, the Sixth Circuit ruled that demand notes
have a maturity date determined by the creditor, and because there
was a fixed rate of interest and regular interest payments, the
lack of a fixed maturity date and a schedule of payments did not
strongly support a characterization of equity.
On the source
of repayment, the Tax Court emphasized Rowe’s testimony
that he anticipated repayment would come from Indmar Products’
profits. The Sixth Circuit ruled that undisputed testimony and
evidence showed that a significant amount of the advances was
instead repaid with the proceeds of loans from FTB.
On the use
of the advances, the Sixth Circuit ruled that the IRS did not
disprove Rowe’s testimony stating Indmar Products used the
advances for working capital, and purchased capital assets with
bank loans. Whether Indmar Products needed the advances when they
were made was irrelevant. As for the absence of a sinking fund,
the Sixth Circuit ruled that it was unimportant, because Indmar
Products was adequately capitalized and had easy access to outside
credit. These factors also made the lack of security less important.
remaining factors, the Sixth Circuit agreed with the Tax Court
that one factor favored equity (the lack of security) and four
favored debt (Indmar Products had sufficient outside financing
available; it was adequately capitalized; the advances were not
subordinate to all creditors; and the Rowes’ advances were
not in proportion to each of their equity interests).
the debt-versus-equity issue, the Tax Court has broad discretion
in applying the factors to a taxpayer’s situation and deciding
the weight given to each factor. As Indmar Products illustrates,
the Sixth Circuit Court of Appeals has significant discretion
too. Nevertheless, accurate generalizations can be made. Debt
treatment is more likely if majority shareholders, making advances
to their corporations, observe debt formalities and make interest
and principal payments on schedule. In addition, corporations
should be able to obtain outside financing from conventional sources.
Courts have allowed this to compensate for deficiencies in the
debt formality factors. Similarly, the ability to obtain outside
financing and strong capitalization can compensate for the lack
of both security and a sinking fund. Finally, it is worth noting
the Tax Court’s ruling in American Underwriters, Inc.,
v. Comm’r, [72 TCM 1511 (1996)], where it found that
shareholder advances were debt largely due to a history of prior
advances and repayments between the parties and the credible testimony
of the witnesses, even though these considerations are not among
the 11 factors.
C. Barton, MBA, CPA, JD, is a professor of accounting,
and Clayton R. Sager, PhD, is an associate professor
of accounting, both at the University of Wisconsin–Whitewater,