Business owners can contribute monies to their business in the form of equity or debt. The tax and business consequences of contributing debt versus equity can be significant. For example, money contributed as debt earns interest, and such interest must be charged at a rate at least equal to the applicable federal rate. If money contributed as debt is not repaid, it can lead to cancellation of debt income. If money contributed as debt is not repaid, the owner can take a bad debt deduction. If money is contributed as debt, payments of interest on the debt are tax deductible, while dividend paid to owners are not.
Sometimes determining whether an interest is debt or equity or part debt and part equity can be difficult. Some interests like preferred stock or convertible debt exhibit characteristics of both debt and equity. The IRS has been working on regulations that would provide guidance on when an interest was debt or equity for federal tax purposes.
IRC section 385 expressly authorizes the IRS to prescribe regulations as appropriate to determine whether an interest in a corporation is to be treated as equity or debt for federal tax purposes. But no regulations are currently in effect, and case law continues to control the characterization of an interest in a corporation as debt or equity.
In early 2016, the IRS published proposed regulations under IRC section 385 concerning the treatment of certain interests in corporations as equity or debt. Included in these proposed regulations was proposed regulation section 1.385-2, which provides rules for the documentation necessary to determine whether an interest in a corporation is treated as equity or debt under the IRC.
These proposed documentation regulations have two main purposes. The first is to provide guidance regarding the documentation and information that must be prepared, maintained, and provided in order to determine whether an instrument will be treated as debt or equity for federal tax purposes. The second is to establish certain operating rules, presumptions, and factors to be taken into account in the making of such determination.
In late 2016, the IRS issued final regulations under IRC section 385 that included the documentation regulations. The final regulations were made applicable only with respect to interests issued or deemed issued on or after January 1, 2018. But in response to taxpayer concerns about implementing these regulations, the IRS has recently decided to further delay the implementation of the documentation regulations. Accordingly, these documentation regulations will apply only to interest issued or deemed issued on and after January 1, 2019.
If you would like to discuss any questions regarding this article or any other federal or state tax matter, please contact Jeff Senney at 937-223-1130 or Jsenney@pselaw.com.