The Department of Treasury and the IRS issued final and temporary regulations under Section 385, which sets forth factors to be taken into account in determining whether an interest issued by a corporation should be treated as stock or indebtedness for tax purposes. This ultimately comes into play when purported debt instruments are issued to or held by certain related parties and not supported by specific documentation. If certain factors are not met, the IRS will treat these purported debt instruments as stock for tax purposes.
The regulations generally apply to debt instruments issued by a domestic C corporation to a holder that is a member of the issuer's "expanded group" or held by a disregarded subsidiary. An "expanded group" essentially means affiliated group, but the definition has been a broader scope to include corporations which might otherwise be excluded from the standard definition of affiliated group.
The rules are extremely detailed and, of course, have a number of exceptions. However, under the main rules, debt instruments may be conclusively treated as stock for tax purposes, regardless of any traditional debt/equity factors in any of the following circumstances:
- When a taxpayer that characterizes an instrument held by a member of the same expanded group as debt, but fails to provide the requisite documentation. This would include evidence of an unconditional obligation to repay the debt.
- If an instrument is issued to a member of an expanded group in a distribution, an acquisition of stock of an expanded group member, or in an asset reorganization pursuant to plan of reorganization where a group member receives the instrument with respect to stock it holds in the asset-transferor.
- If an instrument is issued to an expanded group member in exchange for property with the principal purpose of otherwise funding a distribution, acquisition or exchange among expanded group members.
If the transaction comes into question, the evaluation of the tax classification of the debt instrument will go through four stages of analysis, and if at any point the instrument falls under the equity category, the remaining stages are disregarded and the instrument is treated as equity for tax purposes.
Understanding these rules and getting the proper documentation to meet any requirements under these rules will be crucial in order to avoid potential reclassification of transactions. Where perhaps in the past debt classification of an instrument was made easy, these regulations ensure a more rigid and stringent process.
Maria Vladimirova is an associate with Densborn Blachly, LLP. She has her Masters in Tax Law (LLM) from Boston University where she focused her studies on corporate and partnership tax. As a member of the firm's business group, Maria assists clients with a variety of business transactions, with a special focus on entity work, partnership taxation and corporate reorganizations and acquisitions.
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Categories: Business, Finances, Taxes