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10.2 Tax Refund SuitsDebt vs. Equity The question you must decide in this case is whether the advances made to the Plaintiff corporation by its stockholders created a bona fide indebtedness, that is, were true loans, or whether they were made in fact as investments in the capital of the corporation. The difference between a loan and an investment is important because under the provisions of the Internal Revenue Code, a corporation may deduct from its gross income, for income tax purposes, any amounts paid by it as interest on money that it has borrowed, but it may not deduct other payments such as a distribution of dividends made by it to its shareholders. The fact that the amount paid is taxable in either event, to the people who received the payment, does not matter. In this case the Commissioner of Internal Revenue took the position that the advances made by the stockholders to the Plaintiff were investments in the capital of the corporation, and, therefore, that the payments made by the Plaintiff to its stockholders represented dividend distributions rather than interest payments. As a result, the deductions claimed by the Plaintiff for the payment of this amount as interest were disallowed. The Defendant has the burden of proving, by a preponderance of the evidence, that the Commissioner's determination was correct. Of course, a person may be an investor and a creditor in the same corporation at the same time, but, as I shall explain later, status as one or the other is not necessarily determined by the label that is attached to the transaction or series of transactions. An investment in capital is an advance made to a corporation by a stockholder or stockholders as an investment for the purpose of making a profit dependent upon and measured by the future success of the business. In other words, the stockholder making the advance intends to make an investment and take the risks of the venture.Repayment is not agreed to by the corporation and the investor anticipates a return out of future profits of the enterprise. A return is by no means certain, however, since an investment in capital is similar to any other investment that is dependent upon future profits and earnings. A loan is an advance of money pursuant to an agreement, either express or implied, that the money will be repaid at some future date. The agreement to repay must be absolute, that is, payable in any event. Of course, the lender takes the risk that the corporation may not be able to repay, but the borrower’s legal obligation to repay continues to exist without regard to financial ability or corporate profits and earnings. In general, the essential difference between a stockholder who makes an investment in capital, and a creditor who merely loans money to the corporation, is that the stockholder's intention is to embark upon the corporate venture as one of the owners, taking the risks of loss involved so as to enjoy the chances of profit; whereas the creditor, on the other hand, does not intend to be an owner or to take such risks so far as they may be avoided, and intends merely to lend money to others who intend to take the risk.There is no single factor or test to be applied in making the decision of whether advances by stockholders to a corporation should be considered as loans or investments in capital. You must consider all of the facts of the case; and you must consider the true substance of the transaction, not its form. Names and labels are not determinative- - the fact that the advances are called loans or take the form of inforceable legal obligations under state law is not controlling. The substance, and not the form, is the important thing. A transaction must be examined, for income tax purposes, in terms of what was intended to be accomplished and what was actually accomplished, not from the names or titles or forms used by the parties. Thus, while no single factor should be regarded as decisive, there are a number of things you may consider.One factor you may consider is the presence or absence of a maturity date. The presence of a fixed maturity date indicates a fixed obligation to repay, and is a characteristic of a debt obligation. On the other hand, the absence of a fixed maturity date might indicate that repayment was in some way tied to the fortunes of the business, and would be indicative of an equity advance.A related consideration is whether there was an expectation of payment at maturity. If there was such an expectation, that would be an indication of the existence of a debt. On the other hand, if there is no good expectation of payment at maturity, or if there is an unreasonably postponed due date on the note representing the advance, then that would be an indication that the advance was intended to be investment.Another factor for you to consider is whether the advances made by the stockholders were used for the purpose of buying capital assets [such as machinery] that are essential to the long-range conduct of the business, or whether the advances were merely for current operating expenses. If the advances were for current operating expenses, this might indicate that they were intended to be a loan. If the advances made by the shareholders were made to purchase assets essential to the long-range conduct of the business, this might indicate an investment in capital rather than a loan.If the corporation established a sinking fund (that is, a fund in which money is accumulated to permit a loan to be paid off when it becomes due), did not have the notes of the stockholder subordinated to other indebtedness, and never prevailed upon its stockholders to postpone or forego payments as they became due of amounts that they termed principal, or interest, this would indicate that there was a good expectation of payment at maturity - - that the transaction was a true loan. On the other hand, if the corporation did not establish a sinking fund, did have its stockholders' notes subordinated to other creditors, and did have its stockholders postpone the payments required by the notes, this would indicate that there was no good expectation of payment at maturity - - that the transaction was an investment.Another factor that you may consider is the source of the payments. If repayment is possible only out of corporate earnings, the transaction has the appearance of a contribution of equity capital. If, however, repayment is not dependent upon earnings, the transaction reflects a loan to the corporation.Another factor that you may consider is the right to enforce repayment. If there is a definite obligation to repay the advance, then this is an indication of the existence of a debt.Another factor that you may consider is an increase in participation in management. If the contributors were granted an increased voting power or participation in the affairs of the corporation by virtue of the advance, this would indicate that the advance was intended to be an investment. If, on the other hand, the contributors were not granted any increased voting power or participation in the corporation's affairs by virtue of the advance, this would indicate the existence of a debt. Another factor that you may consider is how other creditors were treated by the corporation. If they were paid on a date certain, upon maturity of the corporation's obligation to them, but advances to the corporation by its stockholders were not so paid, this indicates that the advances by the stockholders were capital investments, and not true indebtedness.Another factor that you may consider is whether there was "thin" or inadequate capitalization. Thin capitalization is evidence of a capital contribution where (1) the debt to equity ratio was initially high, (2) the parties realized the likelihood that it would go higher, and (3) substantial portions of these funds were used for the purpose of capital assets and for meeting expenses needed to commence operations. As specifically concerns the debt to equity ratio, you should keep in mind that if the amount of the debt is much higher, or several times higher, than the amount of capital stock, this would tend to indicate that the advances in question were capital investments. If the amount of debt is more nearly equal to, or is less than, the amount of capital stock, this would tend to indicate that the advances represented true indebtedness.Another factor that you should keep in mind is that if the corporation makes its interest payments but does not pay cash dividends, although it has earnings available for this purpose, this is a factor that may indicate that the advances are capital investment rather than debt. On the other hand, payment of dividends under such circumstances may indicate that the advances are true loans. Also, if the corporation makes so called "interest" payments that are paid only when profits are available, this would indicate a capital investment; if interest payments are made regularly, whether profits are available or not, a true loan is indicated.Another factor that you may consider is the identity of interests between creditor and stockholder. If advances are made by stockholders in proportion to their respective stock ownership, an equity capital contribution is indicated. A sharply disproportionate ratio between a stockholder's percentage interest in stock and debt is, however, strongly indicative that the debt is bona fide.Another factor that you may consider is the ability of the corporation to obtain loans from outside lending institutions. If a corporation is able to borrow funds from outside sources at the time an advance is made, the transaction has the appearance of a bona fide indebtedness. If no reasonable creditor would have loaned funds to the corporation at the time of the advance, an inference arises that a reasonable shareholder would likewise not so act, and the transaction has the appearance of an investment in capital. As stated before, no single factor or consideration is controlling your decision should be made on the basis of all the evidence in thecase.VERDICT[A general verdict form will usually suffice]ANNOTATIONS AND COMMENTSSee the Annotations and Comments following Federal Claims Instruction 10.1, supra.