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US Court of Appeals ruling sheds light on debt vs equity

A ruling by the US Court of Appeals for the Fifth Circuit concerning the transfer of funds from a closely held company to its sole board member provides valuable lessons for taxpayers as to how the courts will decide debt versus equity cases.

Taxable shareholder: income or loan?

The case involved a US neurosurgeon, Frederick Todd, who was employed by his wholly-owned company of which he was director and president. The company had several other employees.

The company established a death benefit only plan for its employees through the American Workers Benefit Fund (AWBF), which later became the United Employees Benefit Fund (UEBF).

Todd obtained a $6 million universal life insurance from Southland Life Insurance (Southland) on behalf of UEBF at an annual premium of $100,000 and the company made yearly contributions to UEBF on Todd's behalf.

Under the agreement, UEBF could make loans to participants on a non-discriminatory basis given evidence of emergency or serious financial hardship.

Todd obtained a $400,000 loan from UEBF for unexpected housing costs. He signed a promissory note for the loan six months after the payment.

Under the loan agreement, interest was supposed to be paid at the market rate with payments to be made quarterly.

However, the note signed by Todd bore only a 1% interest rate.

The note also provided a dual repayment mechanism which allowed UEBF to deduct any outstanding balance on the note from any later distribution to Todd.

The company ceased its payments to UEBF in late 2002 and Todd never made any payments on the note.

Todd argued the $400,000 payment was a loan and therefore tax exempt while the IRS characterised it as a taxable distribution.


The court held that the payment did not constitute a bona fide loan.

It said the fact the note and payment schedule were only adopted after the payment, in contravention of UEBF policies, suggested that doing so was merely a formalised attempt to achieve the desired tax result while lacking in necessary substance. The court also emphasised the fact Todd never repaid any of the loan amount to justify its position.

In making its decision on characterisation of the payment, the court applied a seven-factor test analysing:

  • Whether the promise to repay is evidenced by a note or other instrument;
  • Whether interest was charged;
  • Whether a fixed schedule for repayments was established;
  • Whether collateral was given to secure payment;
  • Whether repayments were made;
  • Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and
  • Whether the parties conducted themselves as if the transaction were a loan.

IRS tax attorney Alvin Brown said the standards used by the court are only indicia of a loan but give taxpayers good guidance on the circumstantial evidence that may be considered on the issue of loan versus income.

Edward Froelich, of Morrison and Foerster, said the standard multi-factor test is definitely applicable beyond the individual taxpayer context and serves as a reminder to companies that proposed transfers of funds from the companies to its executives should be scrutinised to determine the proper tax treatment.

“If the goal is loan treatment the parties must properly document the loan in a timely manner and act in accordance with the note provisions, the taxpayer here was stuck with an additional negligence penalty as a result of failures to properly structure the transaction and follow-through,” said Froelich.

In this case the court placed particular emphasis on whether the loan would be repaid and considered only seven factors, while previous debt versus equity cases have relied upon as many as 13 factors.

Doug Stransky, of Sullivan and Worcester, said this could give an indication of how more usual corporate cases will be treated by the court.

“I think in cases where there is a closely held corporation, where the corporation’s board is the single shareholder, the court is more likely to find equity i.e. dividend treatment and short cut the analysis,” said Stransky.

“This case has relevance for larger companies because it’s distinguishable from the usual corporate cases, so in my view it says if you don’t have a closely held corporation like the Todd case, the court is more likely to look at all of the factors together rather than focus on a single factor,” he added.

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