The IRS Is Looking to Recharacterize Related Party Debt as Equity Simply for Failing to Meet on a Timely Basis New Contemporaneous Written Documentation Requirements

In the early 1980’s, the IRS issued regulations on the question of when loans to corporations would be recharacterized under Code Section 385 as equity. The conversion of purported debt can have significant adverse income tax effects for the borrower and lender. Those regulations were withdrawn and we have been without regulations since then. The IRS has now issued new proposed regulations on the subject.

Below is a short overview of the new regulations and some observations. The proposed regulations are lengthy and complicated, so there will surely be a lot written about the as they are digested by the tax community.

The good news is that unless I am missing something, these rules only apply to purported debt between affiliated corporations, using an expanded definition of affiliation. Thus, purported debt issued to individuals and noncorporate entities should not be subject to these rules.

The bad news is that if the regulations are put into effect, bona fide debt may be recharacterized as equity by the IRS simply because the debt was not put in writing quickly enough, or the taxpayers did not document in writing the ability of the obligor to repay the debt at or around the time of the loan. That is, the IRS will strip away the benefits of debt simply because new regulatory compliance obligations are not timely observed.

Proposed Section 1.385-1 prescribes general definitions and operating rules. -1(d) allows for the IRS to treat purported debt as part equity and part debt – that is, an all or nothing approach is not required.

Proposed Section 1.385-2 imposes documentation and information that taxpayers must prepare and maintain within required timeframes to substantiate the treatment of an interest issued between related parties as indebtedness for federal tax purposes. Such substantiation is necessary, but not sufficient, for a purported debt interest that is within the scope of these rules to be characterized as indebtedness. Even if these rules are complied with, the IRS can still apply general federal income tax principles on the question of debt vs. equity to make a determination to treat debt as equity.

These requirements will be a new burden on taxpayers, and also a trap for the unwary. Such documentation includes a written obligation to pay a sum certain (that is, unwritten promises to pay will not satisfy these rules). Thus, taxpayers who do not document their debt in writing will not be able to get debt treatment.

The proposed regulations also require written documentation containing information establishing that the issuer’s financial position supports a reasonable expectation that the issuer intends to, and would be able to, meet its repayment obligations. I don’t like this at all – it is a new requirement and a trap for those that don’t know about it. Examples of this new documentation include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity and other relevant financial ratios of the issuer in relation to industry averages, and other information regarding the sources of funds enabling the issuer to meet its obligations pursuant to the terms of the applicable instrument.

Making matters even worse, the proposed regulations require that these items be prepared within certain short time frames (30 days and 120 days of the transaction, depending on the particular items). This ignores (intentionally or otherwise) that documentation of loan transactions between related entities often doesn’t occur until the parties eventually get around to it, or are advised by tax professionals to prepare such documentation after such professionals later learn of the transaction or arrangement. These requirements appear as “gotcha” requirements that will deny taxpayers debt treatment for bona fide debts simply for not meeting regulatory documentation requirements. Is the IRS authorized to do this? Is this good tax policy – that is, denying the anticipated tax character of purported debt, not because it doesn’t meet the characteristics of debt but because the IRS issues regulations that require taxpayers to prepare contemporaneous reports demonstrating ability to repay and not allowing taxpayers to prove such ability to repay if the reports were not timely prepared?

This whole regulatory trend of changing basic tax characteristics of items without regard to the substance of transaction or situation because taxpayers do not meet regulatory reporting or documentation requirements is both unfair and disturbing. Another recent example of this is the removal of tax basis from assets that are not properly reported under the new basis reporting rules for assets held in estates required to file an estate tax return – where does the IRS find the authority to remove tax basis from assets? Similar rules also apply in the area of Section 482 where taxpayers must prepare arms-length pricing reports at the time of transactions between related parties if they want to later avoid certain penalties if the IRS does not respect the pricing under Section 482. 

Proposed §1.385-3 provides additional rules that may treat the interest, in whole or in part, as stock for federal tax purposes if it is issued in a distribution or other special types of transactions that are identified as frequently having only limited non-tax effect, or is issued to fund such a transaction.

Proposed §1.385-4 provides operating rules for applying proposed §1.385-3 to interests that cease to be between members of the same consolidated group or interests that become interests between members of the same consolidated group.

The big take away here: if these regulations are put into effect, related party debt between related corporations will not be treated as debt if not in writing, and a written analysis of ability to repay is not undertaken, all within a short time of period of the establishment of the debt. This “penalty” is all without regard to whether the debt meets or does not meet traditional debt elements. If these documentary requirements are met, the IRS can still attack debt under more traditional debt vs. equity elements.

REG-108060-15. Treatment of Certain Interests in Corporations as Stock or Indebtedness