Sixth Circuit Court of Appeals Reverses Debt-Versus-Equity Issue

CPA Journal, The, Apr 2007 by Barton, Peter C, Sager, Clayton R

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.

Background

IRC section 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.

Debt is 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.

In Indmar 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 represents debt:

* A fixed rate of interest and interest payments

* Written 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

* Using the advances for working capital rather than to purchase capital assets

* Establishing a sinking fund

* Giving security for the advances

* Not subordinating the advances to all creditors

* Having an adequately capitalized corporation

* Not making the stockholders' advances proportionate to their equity interests

* 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 case.

Facts of Indmar Products

Richard 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, lndmar 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.

In 1993, 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.

Because 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.

Several 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.

Tax Court Ruling

The Tax 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.