On June 26, 2017, the Supreme Court granted certiorari in PEM Entities v. Levin to decide whether bankruptcy courts should apply a federal multi-factor test or an underlying state law when deciding whether to re-characterize a debt claim as equity. The Court’s decision to grant cert in this case should resolve a circuit split and clarify the law as it relates to re-characterizing corporate debt as equity.
The current system rules related to classifying corporate financing as debt is important for all corporations, but is especially relevant to closely held corporations with only a handful of shareholders. These smaller corporations tend to receive more financing from shareholders in the form of “shareholder loans.” While shareholder loans are a perfectly acceptable method of corporate financing, whether such financing is classified as debt or equity can have a substantial impact on the corporation and its shareholders for the purposes of federal income tax and subsequent bankruptcy proceedings.
For example, classifying a shareholder contribution as debt could allow both the corporation and the shareholder to take income tax deductions or grant the shareholder priority over the other equity shareholders in the event that the corporation later files for bankruptcy.
The simple act of classifying a contribution as debt on the corporation’s books, however, does not end the discussion. Both bankruptcy and tax courts have the power to transform corporate debt into equity, a transformation that could have disastrous consequences for both the corporation and its shareholders. Furthermore, the standards that courts use to determine whether or not to re-characterize debt as equity vary between jurisdictions and are generally unclear.
In Roth Steel Tube Co. v. Commissioner, the Sixth Circuit identified the following factors that lower courts should consider when determining whether debt should be re-characterized as equity:
(1) the names given to the instrument, if any;
(2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments;
(4) the source of repayments;
(5) the adequacy or inadequacy of capitalization;
(6) the identity of interest between the creditor and the stockholder;
(7) the security, if any for the advances; (8) the extent to which advances were subordinated to the claims of outside creditors;
(9) the ability of corporation to obtain loans from outside lending institutions; (10) the presence or absence of a sinking fund to provide repayments; and
(11) the extent to which the advances were used to acquire capital assets.
A note of importance: none of these factors alone are determinative and each may be granted a different amount of weight depending on the facts and circumstances of the situation. Many closely held corporations will satisfy some of these factors but not others therefore making it exceptionally difficult to predict the outcome of any given re-characterization case.
Other jurisdictions, such as the Eleventh Circuit, have identified different tests and factors while other jurisdictions, such as the Fifth Circuit, rely on an underlying state law to determine whether debt should be re-characterized as equity. The fluidity and variety of these tests creates a tremendous amount of uncertainty into any debt re-characterization analysis. While the Supreme Court’s pending decision may not eliminate all of the ambiguity surrounding debt re-characterization claims, it is the first step towards providing corporations much-needed guidance and clarity.