IRS Finalizes Documentation Requirements for Related-Party Debt: The Regulations and Their Effect on Closely-Held Corporations
By J. Daniel Boysen on December 29, 2016
In October of 2016, the IRS issued final regulations under IRC code section 385. The final regulations cover a number of issues under Internal Revenue Code (“IRC”) section 385. IRC section 385 deals, in general, with whether an interest in a corporation should be treated as stock or debt for federal income tax purposes. The purpose of this article is to discuss the documentation requirements under Treas. Reg. § 1.385-2 for related-party debt and touch on what effect these requirements may have on closely-held corporations (click here for a complete copy of the final regulations).
Stock vs. Debt and Closely-Held Corporations
For closely-held corporations (and usually smaller, closely-held corporations), an issue that tends to arise is whether an interest in the corporation was properly classified as stock or debt for federal income tax purposes. What the parties may have intended the interest to be and whether the IRS agrees with the classification upon challenge do not always match up. This is usually due, in part, to a lack of documentation. Closely-held (and usually smaller) corporations may not be keeping adequate documentation regarding related-party interests.
One corporation may have intended to issue debt to a related corporation with hopes of deducting interest payments on the debt under IRC section 163. However, upon challenge by the IRS, the related corporations may be unable to prove their intent without the proper documentation and be denied the interest deduction. In part to try and eliminate this reoccurring ambiguity and place more of an initial and ongoing administrative burden on the taxpayer, the IRS will require threshold documentation requirements that must be met in order for certain related-party interests in a corporation to be treated as debt for federal income tax purposes.
As provided in the regulations, the documentation must include complete copies of all instruments, agreements, subordination agreements, and other documents evidencing the material rights and obligations of the issuer and holder of the interest, and any associated rights and obligations of other parties.
Further, the IRS will require that debt factors be documented:
1. Unconditional obligations to pay a sum certain: There must be written documentation
establishing that the issuer has entered into an unconditional and legally binding
obligation to pay.
2. Creditor’s rights: There must be written documentation establishing that the holder of the
interest has the rights of a creditor to enforce the obligation.
3. Reasonable expectation of ability to repay: There must be written documentation
containing information establishing that, as of the date of issuance of the interest and
taking into account all relevant circumstances, the issuer’s financial position supported a
reasonable expectation that the issuer intended to, and would be able to, meet its
obligations under the terms of the interest.
4. Actions evidencing debtor-creditor relationship: There must be written documentation of
payments of principal and interest claimed to support debt treatment. In the event of
default or similar events, there must be documentation of the enforcement of creditor’s
rights or documentation supporting the non-enforcement of creditor’s rights.
The above-described documentation and information must be “timely prepared.” The documentation and information will be treated as “timely prepared” if it is prepared by the time the issuer’s federal income tax return is filed (taking into account applicable extensions) for the year in which an “event” occurred. Examples of “events” would include the issuance of the interest intended to be debt, an annual credit analysis, or subsequent actions such as the due date for payment of interest or principal.
The final regulations apply only to debt instruments issued on or after January 1, 2018.
The documentation requirements apply to debt issued by domestic corporations that are members of an “expanded group.” In general, an expanded group is a group of entities with a common parent that are 80% owned by vote or value by that parent or other group members. When these regulations were initially issued in their proposed form in April of 2016, many were critical of their far-reaching applicability. In response, the final regulations make changes limiting what corporations must comply. As alluded to above, the documentation requirements do not apply to the debt of non-US issuers. In what may provide relief to closely-held corporations, the documentation requirements do not apply S corporations. Further, the final regulations provide an exemption for relatively smaller corporations/expanded groups. The documentation requirements apply to an expanded group only if when the interest intended to be debt is issued: (1) at least one of the expanded group members’ stock is publicly traded; (2) the expanded group had more than $100 million of total assets; or (3) the expanded group had more than $50 million in annual total revenue.
The final regulations under IRC section 385 establish documentation requirements for related-party debt issued by certain domestic corporations. When applicable, taxpayers will be required to gather and maintain initial and ongoing documentation in order to treat the related-party interest as debt. The documentation requirements could prove administratively difficult and costly for closely-held and/or smaller groups of corporations. However, the IRS has provided relief in its final regulations by excluding S corporations and relatively smaller corporations/expanded groups. For those corporations in which the regulations apply, it will be important to closely monitor exactly what documentation will need to be prepared, maintained, and submitted to ensure the related-party interest is treated as debt for federal income tax purposes. If you have questions regarding the documentation requirements in general, compliance with, or their applicability, please contact Daniel Boysen at (214) 749-2413 or firstname.lastname@example.org.
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