New Debt-Equity Regulations Under the Internal Revenue Code, The
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Missouri Law Review Volume 46 Issue 4 Fall 1981 Article 2 Fall 1981 New Debt-Equity Regulations under the Internal Revenue Code, The Christopher R. Hoyt Follow this and additional works at: https://scholarship.law.missouri.edu/mlr Part of the Law Commons Recommended Citation Christopher R. Hoyt, New Debt-Equity Regulations under the Internal Revenue Code, The, 46 MO. L. REV. (1981) Available at: https://scholarship.law.missouri.edu/mlr/vol46/iss4/2 This Article is brought to you for free and open access by the Law Journals at University of Missouri School of Law Scholarship Repository. It has been accepted for inclusion in Missouri Law Review by an authorized editor of University of Missouri School of Law Scholarship Repository. For more information, please contact [email protected]. Hoyt: Hoyt: New Debt-Equity Regulations under the Internal Revenue Code THE NEW DEBT-EQUITY REGULATIONS UNDER THE INTERNAL REVENUE CODE CHRISTOPHER R. HOYT*t I. Introduction ....................................... 765 II. TaxAdvantages ofDebt .............................. 766 III. Overview of the Regulations ........................... 768 A . Scope ......................................... 768 B. Effect ........................................... 769 C. "Safe Harbor"Escape............................ 771 IV. Key Factorsin the Debt-Equity Determination............ 772 A. HybridInstruments versus Straight Debt Instruments . 772 1. Contingent Paymentsversus Fixed Payments ..... 773 2. Effect of State Law Limits on Stock Redemptions.. 774 3. Subordination .............................. 775 B. Excessive or Inadequate Consideration.............. 775 C. Independent Creditors ........................... 777 D. "SubstantialProportionality" to Stock Holdings....... 778 E. Redemptionsfrom Family Corporations............. 779 V. Classificationof Instruments: The Regulations' AnalyticalFramework ................................ 780 A. Characterat Time of Issue ........................ 780 1. NonproportionatelyHeld Hybrid Instruments .... 780 2. NonproportionatelyHeld Straight Debt Instruments ................................ 781 3. ProportionatelyHeldHybridInstruments........ 781 4. ProportionatelyHeld Straight Debt Instruments .. 781 a. Excessive Debt Test ...................... 782 b. Not-Issued-for-Money Test ................ 784 c. Payableon Demand Test .................. 785 B. Reclassfication of ProportionatelyHeld Debt Instruments .................................... 786 EDITOR'S NOTE: Just prior to publication of this issue, the Treasury Department announced that it would reconsider the regulations discussed in this Article, but did not disclose the changes being considered. *@Copyright 1981 Christopher R. Hoyt. fAssociate with Spencer, Fane, Britt & Browne, Kansas City, Missouri. B.A., 1975, Northwestern University; M.S., 1979, University of Wisconsin; J.D., 1979, University of Wisconsin. The author thanks Robert Lyons and Ronald Langstaff for their constructive comments. Published by University of Missouri School of Law Scholarship Repository, 1981 1 Missouri Law Review, Vol. 46, Iss. 4 [1981], Art. 2 1981] DEBT-EQUITY REGULATIONS 765 1. SubstantialChange in Terms .................. 786. 2. Failureto Pay Interest ........................ 786 3. Demand Instrumentsand Failureto Pay Principal. 787 VI. OtherInterests in CorporationsCovered by the Regulations . 788 A. Loans Not Evidenced by an Instrument ............. 788 B. PreferredStock ................................. 789 C. GuaranteedLoans .............................. 789 VII. Conclusion ......................................... 790 VIII. Glossary ........................................... 792 I. INTRODUCTION One of the most litigated tax issues is whether an interest in a corpora- tion is stock or debt.' Although stock and debt have many similar characteristics, the tax consequences can vary drastically depending on which interest exists. Recognizing the need to end this uncertainty, Con- gress enacted section 385 of the Internal Revenue Code as part of the Tax Reform Act of 1969.2 That section authorized the Treasury Department to issue regulations distinguishing debt from equity for all tax purposes3 and listed five factors that may be considered. 4 On December 29, 1980, the department filed final regulations scheduled to become effective on 1. See generally B. BITTKER & J. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS 4.01-.11 (4th ed. 1979) (comprehen- sive overview of the cases distinguishing debt from equity). 2. Pub. L. No. 91-172, § 415(a), 83 Stat. 613 (current version at I.R.C. § 385). 3. I.R.C. § 385(a). The Congress delegated its authority to the Treasury Department because "[t]he differing circumstances which characterize these situations ... [in which the debt-equity problem can arise] make it difficult for the [Senate Finance] committee to provide comprehensive and specific statutory rules of universal and equal applicablity." S. REP. NO. 552, 91st Cong., 1st Sess. 138, reprintedin [1969] U.S. CODE CONG. & AD. NEWS 2027, 2170. See generally J. MERTENS, THE LAW OF FEDERAL INCOME TAXATION, CODE COMMENTARY § 385 (1981). 4. The Senate report stated that the factors in § 385 need not be given any more weight than other factors. S. REP. No. 552, 91st Cong., 1st Sess. 138, reprintedin [1969] U.S. CODE CONG. & AD. NEWS 2027, 2170. The factors listed in I.R.C. § 385(b) are: (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an ade- quate consideration in money or money's worth, and to pay a fixed rate of interest, (2) whether there is subordination to or preference over any indebted- ness of the corporation, (3) the ratio of debt to equity of the corporation, (4) whether there is convertibility into the stock of the corporation, and (5) the relationship between holdings of stock in the corporation and holdings of the interest in question. https://scholarship.law.missouri.edu/mlr/vol46/iss4/2 2 Hoyt: Hoyt: New Debt-Equity Regulations under the Internal Revenue Code 766 MISSOURI LAW REVIEW [Vol. 46 January 1, 1982. 5 Although the regulations do not clarify all uncertainties, they do establish rules for the taxpayer to determine which interests the In- ternal Revenue Service will treat as stock and which it will treat as debt. II. TAX ADVANTAGES OF DEBT A corporation and its shareholders usually will benefit if an interest in a corporation is classified as debt instead of stock for a variety of reasons. The most commonly cited benefits are that the interest paid on debt is deductible6 and repayment of the principal has no tax consequences. Dividends paid to stockholders, on the other hand, are not deductible by the corporation and are taxable income for the stockholders. For example, an individual might contribute $200,000 to form a corporation. The cor- poration earns $110,000 of taxable income in each of the next ten years, before any payments to the shareholder are deducted. During each of the ten years, the corporation pays the shareholder $10,000, and in the tenth year, it pays him an additional $100,000. If the original contribution is classified as stock, the payments will be treated as dividends. 7 Consequent- ly, the repayments will be taxed twice: the corporation will pay income tax on its earnings and cannot deduct the repayments, and the shareholder will have to report the payments as dividend income. In contrast, if the individual pays $100,000 of the original contribu- tion in exchange for a ten percent, ten year note, the $10,000 annual payments would be characterized as interest paid on debt instead of as dividends. Although the individual will still have to recognize those payments as income,8 the corporation can deduct them as interest 5. The proposed regulations were published in 45 Fed. Reg. 18,957 (1980). See generally Gershman, Debt-equity proposalsprovide guidance but pose prob- lems for small corporations,53 J. TAX. 194 (1980); Pike, ProposedDebt-Equity Regs: PotentNew Standardsfor CharacterizingPurported Debt, 7J. CORP. TAX. 195 (1980). The final regulations were issued in T.D. 7747, 45 Fed. Reg. 86,438 (1980). The regulations were to apply to instruments issued after April 30, 1981. but the effective date was extended to January 1, 1982. T.D. 7774, 46 Fed. Reg. 24,945 (1981). 6. I.R.C. § 163(a). 7. Id. .§ 301(c). Unless granted capital gain or tax deferral status as a redemption or liquidation by another Code provision, a distribution to a shareholder by a corporation made with respect to its stock is taxed as ordinary in- come to the extent that the distribution is a dividend. Id. § 301(c)(1). A dividend is "any distribution of property made by a corporation to its shareholders" out of current and accumulated earnings and profits. Id. § 316(a). If the amount of the distribution exceeds the corporation's earnings and profits, the excess reduces the shareholder's stock basis to the extent thereof. Id. § 301(c)(2). Any excess distribution over the earnings and profits and the basis is recognized as a capital gain to the shareholder. Id. § 301(c)(3)(A). 8. Id. § 61(a)(4). Published by University of Missouri School of Law Scholarship Repository, 1981 3 Missouri Law Review, Vol. 46, Iss. 4 [1981], Art. 2 1981] DEBT-EQUITY REGULATIONS payments on a loan.9 Thus, the corporation will save $4,600 in taxes each year, assuming it is in the forty-six percent marginal income tax bracket.10 The $100,000 payment in the tenth year will be treated as a return of the loan