IRS Section 385 Debt vs. Equity Documentation Rules

In federal tax law, corporations can deduct interest paid on debt, lowering their taxable income, while dividend payments to equity holders are not deductible. This difference creates an incentive for related corporate groups to label arrangements as debt to generate interest deductions, a practice known as earnings stripping.

The Internal Revenue Service (IRS) is authorized under Internal Revenue Code Section 385 to provide rules for determining if an interest in a corporation is debt or equity. These regulations are aimed at preventing mischaracterization and ensuring a transaction’s tax treatment aligns with its economic substance, not just its label.

Scope of the Debt-Equity Regulations

The Section 385 regulations target financial instruments between members of a large, affiliated corporate structure known as an “expanded group” (EG). An EG is defined as one or more chains of corporations connected to a common parent through at least 80% stock ownership by vote or value. While EGs include U.S. and foreign corporations, they exclude entities like S corporations, Regulated Investment Companies (RICs), and Real Estate Investment Trusts (REITs).

The Treasury Department and the IRS issued broad rules in 2016 that included extensive documentation requirements for related-party debt. These specific rules, found in Treasury Regulation §1.385-2, were later withdrawn due to taxpayer feedback.

The recharacterization rules under Treasury Regulation §1.385-3 remain in effect. These rules can automatically convert certain debt instruments into equity if issued during specific transactions, like a distribution to a parent company, that do not involve new investment. Although the formal documentation regulations were removed, the risk of recharacterization for EGs persists.

Required Documentation for Corporate Debt

Despite the withdrawal of the formal Section 385 documentation regulations, corporations must still prove a legitimate debtor-creditor relationship exists under common law principles. The IRS and courts look at a collection of factors to determine the true nature of a financial instrument, and thorough documentation is the best defense against a recharacterization challenge.

A foundational requirement is an unconditional and legally enforceable obligation to pay a specific sum. This should be memorialized in a formal written agreement, such as a promissory note or loan agreement, executed at the time of the advance. The document must clearly state the principal amount, a fixed maturity date or a clear on-demand payment trigger, and the interest rate or the mechanism for calculating it. Ambiguity in these core terms can suggest the advance was a contribution to capital rather than a loan.

The documentation must also establish that the lender possesses genuine creditor’s rights. These are the typical rights a third-party lender would demand, including the right to sue for non-payment, accelerate the repayment of the principal if terms are violated, and potentially seize collateral. The loan agreement should contain standard default and covenant provisions that are commercially reasonable for a transaction of its size and nature.

There must be a reasonable expectation of repayment at the time the loan is made. This means the corporation must prepare and maintain evidence demonstrating the borrower’s financial capacity to service the debt. Such evidence often includes detailed cash flow projections, financial statements, and analysis showing that the borrower could meet its interest and principal payment obligations according to the loan’s terms. Without this analysis, the IRS could argue the lender acted more like an investor taking on risk than a creditor expecting repayment.

Finally, the parties’ ongoing actions must be consistent with a debtor-creditor relationship. This involves the borrower making timely interest and principal payments as required by the agreement. It also means the lender must act like a true creditor and enforce its rights if payments are missed or other terms are breached. A failure by the lender to demand payment or remedy a default can be strong evidence that the arrangement was not a true loan.

Consequences of Recharacterization

When an instrument is reclassified from debt to equity, the tax consequences are significant and impact both the borrowing and lending corporations. The primary effect for the borrower is the loss of tax deductions. Payments that were previously classified as deductible interest are re-labeled as non-deductible dividend distributions. This change increases the borrower’s taxable income, resulting in a higher tax liability, plus potential interest and penalties on the underpayment.

For the lending corporation, the income received is reclassified from interest to dividends. While both are forms of income, their treatment can differ substantially. For a U.S. corporation receiving payments from another U.S. corporation, dividend income may be eligible for a dividends-received deduction (DRD), which can exclude 50% or more of the dividend from taxable income. However, this may not be as favorable as the borrower losing its deduction, and for a lender that is a foreign corporation, the consequences are often more severe.

If the recharacterized payment crosses international borders, such as from a U.S. subsidiary to its foreign parent, the impact is compounded. While many tax treaties reduce or eliminate withholding tax on interest payments, they often permit a withholding tax on dividends, typically at rates of 5% to 15%. A payment that was once flowing to a foreign parent free of U.S. withholding tax could suddenly become subject to a 30% statutory withholding tax, reduced only by an applicable treaty. This reclassification can lead to unexpected cash tax costs and potential issues with claiming foreign tax credits in the parent’s home country.