When is Debt, Debt and When is it Not?
by Robert V. Lally

This question comes up all the time. One of our clients will be starting a new enterprise and they have to put some money into it. The first move is always to fund the new venture with debt. After all, you can always take it back tax free, right? This said there are times when debt is inconvenient. OOPS! It was supposed to be equity. Particularly if the item cannot be repaid, discharge of debt income and the possibility of taxation on the write off, raises its ugly Section 108 head.

Outlined below, in a partnership context, are some of the considerations of when an infusion of money into a partnership is debt and when it is equity. You may be surprised. In reality, most of what is out there is probably really equity all along.

Debt v. Equity is an age old IRS problem. It should be remembered, as a practical matter, that the IRS is virtually always arguing that debt is equity not that equity is debt.

Hambuechen v. Comm. 43 T.C. 90 (1964) In Hambuechen, the Tax Court acknowledged that a partner can be a lender to a partnership. The Tax Court held that the analysis of whether a transaction was a loan or a capital contribution is a question of fact. To resolve this question of fact the Tax Court looked to several factors. These factors were:
• Adequacy of capitalization
• Issuance of notes
• Provision for interest
• Payment of interest
• Presence of a maturity date
• Subordination to other creditors
• Commercial reality, would other lenders make such a loan?
• Security Expectation of payment Use of the funds
• Source of repayment.

Held to the standard of Hambuechen, most partnership and corporate "loans" fail miserably. (In this case, failure is good.) Typically the company is fully leveraged by the first mortgages or other secured lenders. There often is no note. Interest does not accrue. Interest has never been paid. There is no maturity date. The entrepreneur is clearly last in line to be paid. There is no security or collateral arrangement or agreement. Considering the expectation of payment and the source of payment, one can only assume that generally the investor did not look to ongoing operations, at least in the short run, for repayment. Repayment was going to be a long-term process. Accordingly, while it is hard to be definitive in tax law, it is often hard, as a practical matter, to find any indicia under the Hambuechen standard that an investor has a valid loan. Rather, it has always had a capital position.

Federal Projects v. Comm. T.C. memo 1987-202 In Federal Projects, the Tax Court considered the status of various advances made by partners into a series of partnerships. The taxpayer/partner who advanced the funds sought to claim bad debt deductions for the uncollectibility of these "loans." In this analysis, the Tax Court held that the same standard used in the corporate context to measure debt v. equity should apply. The Tax Court also cited Hambuechen. The Tax Court, referencing Section 385 looked to the following factors:
• Written unconditional promise to pay a sum certain on demand or by a certain date.
• Subordination or preference over any other debt.
• Ratio of debt to equity.
• Convertibility to stock.
• Relationship of holdings in stock and debt.

It would be overkill to recite the usual shortcomings in light of the Federal Projects standard (even in the NFL there is 15 yard penalty for piling on). Suffice it to say that most advances do not appear to meet the Federal Projects standard for debt, either.

Kingbay v. Comm. 46 T.C. 147 (1966) In Kingbay, the partners' use of losses was limited by their contributed capital. In order to use more of the partnership losses, the partners sought to have their advances count as additions to their partnership capital. In Kingbay, the Tax Court did recognize the validity of the partnership loans and, to the partners' detriment, did not count the loans as part of partnership capital. In reaching this decision, the Tax Court considered the following factors:
• Repayments were regularly made.
• The loans were not subordinate.
• Notes were executed.
• The loans were bookkept as loans on the partnership books.

The two most powerful factors would appear to be the existence of actual notes and the pattern of repayment.