Debt / Equity Advances To Partnerships
Treatment of Cash Advances between Partners and Partnerships
In Burke v. Commissioner (T.C. Memo 2018-18, February 21, 2018), a recent case decided in U.S. Tax Court, the court held that amounts a taxpayer transferred to a corporation, in which he was a 50% owner, were capital contributions and not loans. This case has brought back to the forefront the important issue of determining whether an interest held by a taxpayer represents debt or equity. Primarily, we will focus on determining debt or equity treatment in the context of a partner advancing cash to a partnership. We will then explain how an advance from a partnership to a partner can receive loan treatment.
Similar to many cases concerning this issue, the Burke case relied on a multifactor analysis in determining whether a cash advance to the business
entity in substance more resembles a capital contribution or a loan. Specifically, the Burke court relied on the 11 factors articulated in A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970).
The table below lists the11 factors utilized in Burke
along with a description of when a factor leans toward a debt or equity classification.
names given to the certificates evidencing the indebtedness.
|Lack of contemporaneous written loan agreement or|
other documentation favors equity classification.
|The presence or absence of|
a maturity date.
|No maturity date would favor equity classification|
|The source of the payments.||Repayments of advances out of profits would be|
indicative of equity classification.
|The right to enforce the|
|Debt claims are legally enforceable.|
|Heavy participation in management would favor equity|
classification. However, partner can act in the dual capacity as both an
equity holder and lender. (See
Internal Revenue Code §707.)
|A status equal to or|
inferior to that of regular creditors (subordination in liquidation).
|In a liquidation scenario, creditors typically share in liquidation|
proceeds before partners or shareholders.
|The intent of the parties.||This would encompass the intent of the parties at|
time of the agreement.
|“Thin” or adequate|
|“Thin” capitalization is strong evidence of a capital contribution|
where: “(1) the debt to equity ratio was initially high, (2) the two parties
realized it would likely go higher, and (3) a substantial portion of the
funds were used to purchase capital assets and for meeting expenses needed to
|Identity of the interest|
between creditor and equity holder.
|Advances in proportion to the partner’s capital interest|
in the partnership indicate equity classification.
|The payment of interest|
only out of “dividend” or distribution money.
|Payment of interest out of distributed profits indicates equity|
treatment as payment is dependent upon future earnings or increased market
value of interest.
|The ability of the entity|
to obtain loans from outside lending institutions.
The inability to secure financing in an arm’s-length
None of the factors in isolation necessarily determine debt or equity classification and they therefore should be considered together. Factors utilized in other cases also include the regularity of interest payments, the interest rate charged, and the substance of the transaction apart from intent.
Thus, when a partner advances cash to a partnership, the transaction should be structured and documented in such a way as to meet the factors that lead to the desired treatment. There is also precedent (see Investors Insurance Agency Inc. v. Commissioner [T.C. 1027 (1979)]) for structuring the transaction on the borderline between debt and equity that allows for subsequent minor changes altering the tax treatment of the advance. In addition, the partnership agreement could provide specific direction as to how to structure any debt or equity investment so as to ensure the parties receive the intended treatment.
Resolution of the proper classification of the advance will result in one of the following tax treatments:
- The advance represents a bona fide loan from a third-party (i.e., the partner acts in the capacity of a creditor).
- Under IRC §707(c), payments to a partner that are determined without regard to partnership income represent “guaranteed payments” includible in the income of the partner and deducted (or capitalized) by the partnership. Under this scenario, the payments qualify as guaranteed payments for the use of capital.
- The payments depend upon the generation of income by the partnership and thus represent partnership distributions as provided in IRC §731. The partner must include the payments in income as distributive shares of partnership income items.
In the case of a partnership advances to a partner requiring repayment, IRS regulations indicate that the transaction will qualify as a loan if the repayment terms are, in fact, legally enforceable. However, legal enforceability in and of itself does not constitute a sufficient basis to qualify the advance as a loan. The partner must also pay interest on a regular basis, the terms must set forth a specified repayment date, the partnership must charge a reasonable rate of interest, collateral should be required, and the indebtedness should be evidenced in writing. According to Revenue Ruling 73-301, an advance creating a deficit in a capital account is not a loan. This remains the case even if state law or the partnership agreement requires the partner to restore the deficit.
Finally, according to Revenue Ruling 57-318, the subsequent cancellation of a bona fide loan to a partner results in a deemed distribution of money to the partner. This can result in gain to the partner but only to the extent the deemed distribution exceeds the partner’s basis in the partnership interest immediately before the cancellation.
For more information regarding debt or equity classification of advances between partners and partnerships please seek the advice of a tax professional.