What Is Rev Proc 75 17 and When Does It Apply?

When a corporation receives funds from a shareholder, the IRS may question whether the transaction is a genuine loan or a disguised equity contribution. The distinction is important because the tax treatments for debt and equity are different. Interest paid on corporate debt is a deductible business expense for the corporation, while dividend payments on equity are not. For the shareholder, repayment of a loan’s principal is a tax-free return of capital, whereas a dividend is taxable income.

Corporations and shareholders should structure any loan arrangement carefully to ensure it is respected as debt by the IRS. The determination is based on a multi-factor analysis from court cases that assesses the economic reality of the transaction.

Key Factors in Determining Debt vs. Equity

There is no single checklist for classifying an instrument, but courts look at several factors to determine the nature of a shareholder transaction. The more of these factors that point toward a debtor-creditor relationship, the more likely the IRS will respect its classification as debt.

One of the most important factors is the existence of a formal, written debt instrument, such as a promissory note. This document should contain the fundamental terms of a real loan, including a reasonable interest rate, a fixed payment schedule, and a specific maturity date. The interest rate should be comparable to what the corporation could obtain from an unrelated, third-party lender. A loan with no fixed maturity date or one that is repeatedly extended may be viewed as a permanent investment rather than a temporary loan.

Another consideration is whether the shareholder’s debt is subordinated to the claims of the company’s general creditors. In a true loan, the lender expects to be repaid on par with other general creditors. If a shareholder agrees that their loan will only be repaid after all other creditors are satisfied, it suggests the funds are at greater risk, similar to an equity investment.

The corporation’s ability to repay the loan from its ongoing operations is also scrutinized. If the company is thinly capitalized—meaning it has very little equity and a high amount of debt—the IRS may argue that any additional funds from shareholders are necessary infusions of capital, not loans. The expectation of repayment should be based on the company’s financial stability and projected cash flow, not just on the hope of future profits.

Finally, the IRS often looks at whether the debt is held in proportion to stock ownership. When shareholders lend money to their corporation in the same proportion as their stock holdings, it can suggest that the “loans” are simply another way of funding the company as owners. In an arm’s-length transaction, a loan from a third-party lender would not be contingent on the lender also being a stockholder. While not automatically fatal, proportionality is a red flag that invites closer examination.

Consequences of Recharacterization

If the IRS determines a shareholder loan is an equity investment, it will be recharacterized as equity. This reclassification triggers tax consequences for both the corporation and the shareholder.

For the corporation, the primary impact is the disallowance of interest deductions. Payments treated as deductible interest are reclassified as non-deductible dividend distributions, which increases the corporation’s taxable income and results in a higher corporate income tax liability.

For the shareholder, the consequences are equally problematic. Payments received and intended as principal repayments on the loan would no longer be treated as a tax-free return of capital. Instead, these payments would be reclassified as taxable dividend income to the extent of the corporation’s earnings and profits. This means the shareholder would have to pay income tax on money they believed was simply the repayment of a loan.