One often overlooked debt-equity issue is presented by continuing transfers to a subsidiary that is reasonably creditworthy at the inception but subsequently encounters difficulties, in spite of which (or maybe because of which) and continues to receive advances from the common parent or one of its finance subsidiaries. The issue is whether the subsequent difficulties should cause the advances made after some point in time to be equity rather than debt.
Scott Singer Installations, Inc. v. Commissioner, T.C. Memo. 2016-161, [read here] involves a corporation that began business in 1981 and operated with some success. In order to fund its growth, its sole shareholder began to borrow from other persons and relend the proceeds to the corporation in 2006. (No notes were executed; no interest was charged; and no maturity dates were imposed.) The corporation was initially profitable, but experienced a decline in business in 2008. The court held that the shareholder loans from 2006 through 2008 constituted debt because the corporation’s success provided a basis for the shareholder’s having a reasonable expectation that those loans would be repaid, but that the funds transferred after 2008 were not debt because as a result of the decline in business, the shareholder “should have known that future advances would not result in consistent repayments.”
The court cited no case in which this approach was applied. Whether shareholder could have a reasonable expectation of repayment is a factual issue for which authority is not needed. However, this approach is somewhat unusual. A particularly difficult question in many cases is the point after which advances should be treated as equity. The general downturn in the economy may have simplified it here. It is important to note that the advances made before 2009 were not recharacterized as equity; it appears that if it were appropriate to treat them as debt when they were made, they remain debt.
The Tax Court in Scott Singer focused heavily on the lender’s reasonable expectation of repayment in characterizing the later advances as equity. However, it is important to note that the debt-equity determination is often extremely complex and fact-specific. The question of lending to a troubled company arises frequently in the third-party lending context. In these situations, a lender often seeks a higher interest rate and/or additional collateral to account for the problems that the company is experiencing. When a third-party lender extends credit to a troubled company, they often look to assets and their priority relative to other creditors in considering whether to loan additional funds.
Business people at a company need to be cautioned that pumping money into a subsidiary that is sustaining losses (and probably needs the money to prevent sinking) may lead to adverse tax consequences unless the entity’s stock becomes worthless. One approach may be to have the subsidiary issue a combination of notes and preferred stock.