Four Categories of Features to Show Debt or Equity

Four Categories of Features to Show Debt or Equity to Internal Revenue Service (IRS)

1. Features about the parties formal rights and remedies LEGAL RIGHTS 
1. What legal rights and remedies in the contract 
2. Maturity date- usually for fixed term if lender 
3. Participation in Corporate Gains- Generally associated with equity interests that participate in the corporate adventure, although some debt securities have upside advantage d. Participation in Corporate losses. Debt holders don’t participate 
4. Certainty of Return – Dividends legally only if the corp has adequate earnings or surplus. Credits have an unconditional right to get the interest on their contract.  You pay all the time.  
5. Remedies upon default- legal- if the company does not pay, the creditors may sue for the amount. Lenders can force debtors into bankruptcy. 
6. Right to convert debt into stock, at will, then the question will be in what way was this ever really debt? Convertible securities. 
7. Subordination- Important with bankruptcy, who has the prior claim to the corps earners and assets. Equity holders subordinate.  Priority of interest holders 
8. Voting Control – Equity holders often have voting powers, but it is an equity like feature 2. Facts showing the parties intent? 
2. What evidence is available to show that the arties want. OBJECTIVE TEST. What the parties are doing at time of deal. 
1. All the documents surrounding the transaction. Totality of the circumstances will be looked at. Written and Oral Communication.
2. What is the document labled? Promissory notes.
3. What happens when parties don’t observe the formalities. 
4. Do the specify the terms of the debt and keep referring to it as debt.
5. If the parties are related, does this look like stock that unrelated parties would exchange
6. What about the accounting books. Label it correctly in records and balance sheet
7. Parties practices matter. If there is purported right to interest, but the corporation never pays the right amount. Irregular paying dividends. 
8. Paying dividends before interest payments does not look so good either. 
3. Economic reality of the instruments 
1. Two important economic factors: 
1. Do the parties debt interest, mirror the parties equity interests? This raises the possibility that maybe its just equity disguised as debt. Look at proportions. 
2. Thin Capitalization- Lots of equity
1. Debt without much equity looks like an equity investment. 
2. Look for factors that are pointing more at a corporate adventure. 
4. What the parties say at the actual time of the dispute – Subjective. How they label it. It counts for something.  
1. Different taxpayers have different incentives. These factors often matter the most with hybrid securities because they have many different characteristics.  
2. When does IRS come in? When parties do not negotiate at arms length. The courts are particular skeptical of non- arm lengths negotiations.