Can new debt vs. equity regs provide a good guide for S corporations?
The IRS issued final and temporary regulations under Section 385 late last year describing characteristics that help determine whether an investment in a corporation is debt or equity. Although those regulations exempted S corporations from their application, they nonetheless provide guidance and insight that can be useful to an S corporation that might be structuring a cash infusion that it intends to treat as debt.
This distinction between equity and debt can be extremely important for S corporations concerned about preservation of the corporation's subchapter S status. Purported debt that the IRS might recharacterize as equity could create a second class of stock. That recharacterization could potentially terminate the company’s status as an S corporation. For this reason, the final and temporary regulations provide useful insight to taxpayers concerned about this issue and the factors the IRS may consider important.
For example, the importance of following the proper formalities when structuring debt agreements, an area of emphasis within the Section 385 regulations, was recently emphasized in Sensenig v. Commr. TC Memo 2017-1. In that case, the taxpayers owned an S corporation that advanced money to several lower-tier entities. Their intention was that the advances be treated as loans. However, the S corporation never executed formal loan agreement, did not charge interest, and did not provide a fixed maturity date. As a result, the court concluded that the advances were contributions to the entities’ capital and not loans, which prevented the company from taking bad debt deductions.
The section 385 regulations and this case are good reminders that the debt versus equity issue continues to be significant for S corporations and can create unique issues if it is not monitored closely. Although IRS agents may have been instructed to not use these regulations against S corporations, they can still be helpful to S corporations interested in taking all necessary precautions to avoid a recharacterization.