United States

Stapled debt and equity represent a trap for the unwary


A corporation generally has a tax incentive to issue debt as opposed to equity (i.e., corporate-level interest deductions and reduced earnings and profits). Understanding this benefit, many private equity funds, investors and strategic acquirers alike structure equity investments with a mix of debt and equity. However, in many situations, the debt and equity investments are intended to be held by the investor throughout the life of the investment and are not necessarily separable, which brings into question the issue of whether the investments are “stapled.” When debt and equity are legally or substantively stapled together, the tax benefit of the interest deductions is at risk.      

Stapled investments are seemingly distinct securities (e.g., debt and equity) that are inseparable by the terms of the investment – hence the term “stapled.” While separate in form, the investments limit a holder, either legally or in substance, from disposing of one without the other. Where a debt and equity investment is stapled, the stapled instrument is generally considered an equity investment, thereby eliminating the tax benefit associated with the debt.

The IRS may view arrangements where debt and equity cannot be separated as strictly equity securities. This was at issue in Universal Castings Corp. v. Commissioner (37 TC 107 (1961), aff'd, 303 F.2d 620 (7th Cir. 1962)), where the Tax Court held that because notes and stock were “locked-in” as a single investment, no debtor-creditor relationship existed. Universal Castings’ debt interests existed in tandem with its equity interests at all times. The tandem nature of the locked-in feature was further emphasized by a shareholders’ agreement requiring shareholders to issue debt to the corporation in direct proportion to their stock ownership and precluding shareholders from selling either notes or stock without the other. Further, due to the stapling function, an investor’s interest as creditor could never differ from its interest as a shareholder. As a result, the Tax Court disallowed the corporate interest deductions, claiming the investment was strictly equity.

In summary, while a taxpayer often has legitimate, non-tax motivated business reasons to enter into stapled financing, the IRS may attempt to eliminate the tax benefits associated with debt financing. To avoid this, taxpayers should work with their tax advisors in creating their investment structure to assure the debt and equity investments are not stapled.

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