Intercompany debt: Handle with care

It’s common for related companies (e.g., brother-sister or parent-subsidiary) to lend money to one another, particularly when one needs financial support. To ensure the transaction is treated as a loan for tax purposes, the parties must structure and document it as bona fide debt from the outset. Otherwise, the IRS may recharacterize it as an equity contribution, potentially triggering unintended tax consequences.

In some situations, however — such as in the Fry v. Commissioner case discussed below — equity treatment may be preferable, making proper characterization equally important.

Example scenario

Here’s a common example of how related companies can get themselves into trouble:

Companies A and B are owned by the same group of shareholders. Company A is unprofitable and needs financial support to keep its operations afloat. The shareholders cause Company B to lend Company A the funds it needs. However, they don’t execute a written promissory note, establish a fixed repayment schedule, charge a reasonable rate of interest or treat the arrangement as a loan in their books and records. Company B makes no effort to collect the purported loan. The expectation is that Company A will repay it once it becomes profitable.

The IRS finds that the arrangement isn’t a bona fide debt and recharacterizes it as 1) a constructive dividend from Company B to its shareholders, followed by 2) a capital contribution by the shareholders to Company A. This results in several unintended tax consequences. Not only are the constructive dividends potentially taxable to the shareholders, but any payments by Company A to Company B will be treated as distributions rather than a combination of principal repayments and deductible interest.

Debt vs. equity

The U.S. Tax Court’s 2024 decision in Fry provides valuable guidance on the factors courts consider when determining whether transfers of funds between related companies constitute debt or equity. This case involved an individual who was the sole shareholder of two S corporations, Crown and CR Maintenance (“CR”). Crown’s business was the collection of trash and recyclables, while CR processed those materials into commodities for sale to third parties. The two companies operated in the same facility, and their operations were integrated.

CR experienced significant losses, so Crown transferred funds to CR and made direct payments to CR’s creditors to cover its expenses. By the end of 2013, these transfers and payments totaled more than $36 million.

Typically, taxpayers argue for debt treatment. In this case, however, even though the transfers were treated as loans in the companies’ books and tax returns, the shareholder argued that the transfers were constructive dividends followed by equity contributions. That’s because an equity contribution would increase his basis in CR, allowing him to deduct millions of dollars in losses. The IRS challenged this characterization.

To determine whether the transfers and payments were debt or equity, the Tax Court weighed several factors and concluded that they were equity contributions. Several factors weighed in favor of equity, including:

There was no maturity date,
Repayments were conditioned on CR’s future profitability,
Crown didn’t obtain a security interest, demand payment or collect interest from CR,
Crown’s right to repayment was subordinate to regular creditors,
The interests of the shareholder, Crown and CR were “significantly intertwined,” and
There was no expectation that CR would make interest payments; rather, payments would come from future earnings or distributions.

Only one factor weighed in favor of debt: Initially, the companies treated the transfers and payments as indebtedness in their books and records, indicating an intent to classify them as debt.

Document carefully

Whether transfers between related companies are intended as loans or capital contributions, it’s critical that the parties structure and document the transactions in a manner consistent with the desired treatment.

In Fry, though the taxpayer prevailed, he could have avoided the cost of lengthy litigation by documenting the transaction as a distribution from one company followed by a capital contribution to the other, and treating it as such in the companies’ records and on his personal tax returns.

If you’re considering an intercompany transaction, consult your tax advisor for guidance. He or she can help you avoid unintended tax consequences and ensure it’s properly structured and documented.

Structuring shareholder loans

The main article discusses intercompany debt, but similar considerations apply to loans from shareholders to their companies. Often, there are significant tax advantages to treating these transactions as debt rather than capital contributions, including avoiding potential taxes on distributions and allowing the company to deduct interest payments.

To ensure that a loan is properly classified as such for tax purposes, it’s important to treat it like other arm’s-length lending transactions. That means executing a promissory note, charging a commercially reasonable interest rate, establishing and adhering to a fixed repayment schedule, securing the loan with appropriate collateral, recording the transaction as a loan in the company’s books and ensuring reasonable collection efforts are made.