Whether a corporate investment is, for tax purposes, a shareholder loan or an equity contribution is a difficult question, and federal statutes and Treasury Regulations provide few, if any, clear answers.

Three Major Factors

The courts are likely to look to varying combinations of factors rooted in the Sixth Circuit Court of Appeals’ 2006 decision in the Indmar Products Co. case. While no single factor is conclusive, the following three factors have been shown to be particularly important. Their presence indicates the existence of a fixed legal obligation to repay, which is the most important characteristic of bona fide debt.

Document Description. The courts pay close attention to the names given to the instruments evidencing the purported indebtedness. Obviously, if shareholder advances are not described as loans payable on the corporation’s books and as loans receivable in the shareholder’s financial records, the case for treating shareholder advances as debt is weakened. Conversely, the presence of promissory notes or other written evidence of indebtedness (such as a written line-of-credit agreement) is a strong indication that the shareholder advances are loans and not equity contributions.

Repayment Schedule. The presence or absence of a fixed maturity date and defined schedule of payments is another powerful factor in distinguishing debt from equity. According to Indmar, fixed maturity dates and repayment schedules are not required for bona fide demand loans (payable upon the demand of the shareholder-lender). That said, loans with a fixed maturity date and repayment schedules are more convincing than purported demand loans.

Interest Rate and Payments. Courts will also strongly consider the presence or absence of a fixed rate of interest and actual interest payments. Presence of this factor indicates bona fide debt rather than equity; absence indicates the opposite.

It is important to consider what interest rate a bank or other outside lender would charge for the same loan, as paying extraordinarily high interest to shareholders might indicate that a distribution of profits to the shareholders is being disguised as debt payments.

Beyond these three prominent factors, the courts are likely to consider other elements of the Indmar ruling.

Capitalization. How adequate is the corporation’s capitalization? An excessively high existing debt-to-equity ratio is indicative of shareholder cash advances being equity.

Overlap between Shareholders and Lenders. Determining the extent to which advances by shareholders are proportional to the ownership interests of the shareholders in the corporation is an important factor. If advances are made by shareholders in proportion to their respective stock ownership, an equity contribution is indicated rather than bona fide debt. (This factor is relevant only if there is more than one shareholder.)

Security. Lack of collateral to secure a shareholder advance indicates an equity contribution rather than a loan. The company should provide collateral, with documentation, to secure the company’s repayment obligations to the shareholder.

Availability of Outside Loans. The fact that the company has historically obtained or is able to obtain financing from a bank or other outside lender is also a factor. When a corporation has the ability to obtain outside debt financing, it is more likely that purported shareholder loans are, in fact, debt rather than equity. There is no tax law requirement for a corporation to borrow from commercial lenders when shareholders are willing to provide loans. In such cases, properly structured shareholder advances should be respected as legitimate loans.

Subordination. Finally, courts will consider the extent to which the purported shareholder loans were subordinated to the claims of outside creditors. Subordination to debts owed to all outside creditors is indicative of equity.

Again, in most cases the courts are unlikely to view any single factor as controlling or decisive; rather, they are likely to consider a combination of factors that are relevant to the case. Generally speaking, the more a shareholder advance resembles an arm’s-length transaction, the more likely it is to be treated as debt for interest expense deduction purposes.