A company may need additional funds, and one option as an owner is contributing funds in the form of debt and promissory notes, instead of equity. Some of the benefits of contributing funds as debt instead of equity are the interest paid can be treated as tax-deductible, and the contribution can have priority over equity holders in the event of bankruptcy. See e.g., Matthew T. Schippers, The Debt versus Equity Debacle: A proposal for Federal Tax Treatment of Corporate Cash Advances, 64 U. Kan. L. Rev. 527, 528 (2015). However, the IRS may attempt to argue at some point that the interest was dividends, and therefore not tax-deductible. This could result in double-taxation depending on the type of company created and its tax status. Id. The courts have specific factors when determining the economic reality of a contribution and whether it should be treated like debt or equity.
The Sixth Circuit Court of Appeals in Indmar Products Company v. C.I.R. affirmed eleven, non-exclusive factors to determine whether the economic reality of the contribution was debt or equity. 444 F.3d 771, 777 (6th Cir. 2006) (quoting Roth Steel Tube Co. v. Comm’r, 800 F.2d 625, 630 (6th Cir. 1986). Four of those factors are 1) the name describing the instruments, 2) whether there is a fixed maturity date, 3) whether there is a fixed rate of interest, and 4) whether those new funds were used for capital assets. Id. Some other courts have additional factors, but many still state that those factors are guidelines, and their analysis is not limited to only those.
The courts point out, however, that each situation is different. The eleven factors should be applied to each case, with its particular facts. Id. To make sure that a debt contribution is actually considered to be debt by the courts and IRS, it is important to think about the different factors – before the loan is made.
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