The Latest: Debt v. Equity Regulations
In October 2016, the IRS issued proposed regulations on when to treat an interest in a corporation as debt or equity under Code §385.
Specifically, the proposed regulations, which cross-reference temporary regulations also issued in October 2016, provide rules that treat certain debt as a stock that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction “that achieves an economically similar result” (i.e., the “Distribution Regulations”). Among other things, the Distribution Regulations address certain qualified short-term debt instruments and transactions involving controlled partnerships and consolidated groups. Recently, the IRS released final regulations (TD 9897), effective on 5/14/20, that adopt without any substantive changes the 2016 proposed regulations. (Code §385; Debt v. Equity)
Comment: The IRS “will continue to study the appropriate approach” to revising the Distribution Regulations in the future. On another note, the TCJA enactment of Code §163(j) makes this distinction of debt v. equity somewhat moot insomuch as we now have a cap on the deductibility of interest expense even where there is no question that outstanding debt is involved.
Also, always look at the common factors which are examined when doing this analysis of “debt v. equity.” Namely, as outlined in Dixie Dairies Corp., 74 T.C. 476 (1980), the courts will look to whether there is “thin capitalization” and whether outside third-parties would have lent monies to the taxpayer given the current circumstances. Also, is the “debt” evidenced in writing, and is there any repayment schedule (or at least interest paid on this “debt”)?
Authored by:
Dr. John Connors, JD, CPA, LLM
Tax Educator’s Network, LLC
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