Tax Implications of Debt vs. Equity in Related Entities

Investors who engage in successful ventures often also invest in less successful ones. In some cases, one venture ends up funding another. When a taxpayer operates through multiple legal entities, this can lead to numerous complexities.

For example, “due to” and “due from” intercompany transactions raise questions, even if they do not involve international transfers. These transactions may prompt concerns about whether taxpayers are using intercompany transactions to minimize their tax liabilities. Indeed, there are tax planning opportunities that can be leveraged for this purpose.

In the absence of tax planning, intercompany transactions can raise other questions, such as whether a debt results in the cancellation of debt income and/or tax losses when it is not repaid. There may also be questions about whether the debt is genuine or if it is a capital contribution. These situations involve the application of bad debt rules and worthless securities rules.

The Keeton v. Commissioner, T.C. Memo. 2023-35, case addresses this scenario, enabling us to examine the interplay between the bad debt and worthless securities rules. This case and these rules can help inform taxpayers about their investment decisions and tax planning strategies. This is especially relevant as the IRS frequently audits tax losses.

Facts & Procedural History

The taxpayers in question were a husband and wife who owned a landfill company. The company experienced financial losses and eventually filed for bankruptcy.

Before the bankruptcy, the landfill company received funds from another entity, which the taxpayers owned 50% of and controlled. This other entity recorded advancements to the landfill company as “due from” entries in its QuickBooks accounting records. Over time, a bank provided a loan to the landfill company, which was later repaid by a third party that advanced the funds.

To make the balance sheet figures more appealing to potential lenders, the loans to the related entity were converted to equity. The business records documented this conversion, stating, “the liability for the notes payable shall be eliminated by converting the notes payable to paid-in capital for each of the respective shareholders.”

When securing additional loans proved impossible, the third party that had advanced the funds foreclosed on the landfill property, which led to the bankruptcy.

This case focuses on the bad debt deduction claimed by the related entity that converted its debt to equity. As this entity was a partnership, it passed the loss through to the individual income tax returns of the owners.

Upon auditing the owners’ individual income tax returns, the IRS disallowed the flow-through losses for the bad debt deduction. Consequently, the case revolved around the tax treatment of these losses.

Bad Debt Tax Deduction

Section 166(a)(1) states that any bona fide debt that becomes worthless within the taxable year results in an ordinary loss deduction.

A bona fide debt stems from a valid debtor-creditor relationship based on an enforceable obligation to pay a fixed sum of money. Capital contributions are not considered debts for this purpose.

To determine if a fund advance constitutes genuine debt, courts examine the overall transaction, focusing on the taxpayer’s intent to create debt with a reasonable expectation of repayment and the establishment of a debtor-creditor relationship. The transaction’s outward form is not decisive; rather, the taxpayer’s actual intent, as demonstrated by the advance’s circumstances, is crucial.

In this case, the court did not need to delve deeply into the debt-versus-equity analysis due to the debt-to-equity conversion. The court observed that the unanimous consent resolution in 2012 converted all existing shareholder loans into equity. Consequently, no debt from the landfill company could have become worthless.

The taxpayers argued that the resolution did not impact the alleged loan from the related entity since the related entity was not a shareholder in the landfill company. The individuals who owned the related entity were the landfill company’s shareholders. Therefore, the taxpayers contended that the consent only converted their personal loans to equity in the landfill company. If true, the taxpayers’ position might have been valid. However, the court noted that the landfill company’s financial statements from 2008 onward contradicted the taxpayers’ claim by classifying loans made by stockholders as “Notes Payable — Stockholders.” In summary, the court rejected the taxpayers’ argument. This is really a case about controlling records and information that makes its way into the court record–and making an affirmative decision as to whether to an advance is a loan or a capital contribution up front.

Debt vs. Equity Factors

The courts have identified eleven factors to consider when determining whether a transfer to a corporation by a shareholder is a debt or a contribution to capital.

The factors for this debt-vs-equity analysis include the names given to the debt certificates, presence of a maturity date, source of payments, right to enforce payment, advances increasing participation in management, status of the lender compared to regular creditors, objective indicators of intent, capital structure of the borrower, proportion of funds advanced to shareholder’s capital interest, source of interest payments, and the borrower’s ability to obtain loans from outside institutions.

The courts have confirmed that no single factor is decisive, and the court evaluates these factors based on the particular circumstances of each case. The taxpayer bears the burden of proving that the advances were loans rather than capital contributions, however.

In the present case, the court examined the debt-vs-equity factors and concluded that they indicated this was equity, not debt. There were no promissory notes, the records referenced “capital” instead of loans, the accounting records tracking debts for the entities were inconsistent, there was no maturity date, the landfill company was not creditworthy and was thinly capitalized (see this article about bad credit being the deciding factor), and no interest payments were made. The taxpayers did not document that this was a loan.

Given this holding, the court sided with the IRS. It held that the taxpayers were not entitled to a bad debt deduction.

What About a Worthless Security Loss?

The court considered a bad debt deduction under Section 166. Section 166 does not apply to debt that is evidenced by a security. This worthless security loss is set out in Section 165(g).

Section 165(g) allows taxpayers to treat the loss from certain types of worthless securities. Given the court’s finding that the loan was actually a capital contribution, it would seem that the implication is that the taxpayers are entitled to a worthless securities loss under Section 165(g) for their investment in the landfill company. The landfill company filed for bankruptcy in 2016—one of the years before the court.

The challenge is obtaining ordinary tax treatment rather than capital tax treatment for the worthless security. A loss under Section 165(g)(2)(C) is considered an ordinary loss, rather than a capital loss, if it meets the following criteria:

1. The security must not be a capital asset in the hands of the taxpayer, meaning it is not held for investment purposes. Capital assets generally include stocks, bonds, and other property held for investment, while assets used in a trade or business, such as accounts receivable and inventory, are not considered capital assets.
2. The security must be a bond, debenture, note, certificate, or other evidence of indebtedness, issued by a corporation or a government or political subdivision thereof, with interest coupons or in registered form.

The first requirement looks at the intent of the party who advanced funds. Did they do so for a business or investment purpose? For example, advancing funds to help a key supplier stay in business could be a business purpose. Advancing funds to put money into a related entity with the hope of a return on investment is likely an investment.

The court does not address a tax loss for worthless securities, but had it done so, the taxpayers might have been able to achieve the same tax treatment as with their worthless debt position. The difference is that the loss may have been larger, as it appears they invested more into the entity than the amounts they wrote off as bad debts.

The Takeaway

This case underscores the complexities that emerge when taxpayers invest in multiple ventures through distinct legal entities. Intercompany transactions, such as “due to” and “due from” entries, can raise questions about tax planning strategies and the nature of the debt, including whether it results in cancellation of debt income, tax losses, or even whether it constitutes genuine debt or a capital contribution.

The case showcases the importance of the bad debt and worthless securities rules, and how they interact in determining the tax treatment of losses. It is crucial for taxpayers to meticulously analyze their investments and transactions to ensure accurate classification of debt versus equity, as well as to remain cognizant of the potential tax implications. Ultimately, thorough investment analysis, expert tax attorney advice, and strategic planning and documentation are essential for securing the desired tax treatment and effectively addressing any potential IRS challenges.