Estate of Fry: Tax Court Rules for Taxpayer on Related-Party Advances

A recent Tax Court opinion has garnered attention with respect to the treatment of certain obligations as either debt or equity for tax purposes, an issue that can involve significant uncertainty and generally requires a facts and circumstances analysis in each case. In Estate of Thomas H. Fry v. Commissioner of Internal Revenue, TC Memo 2024-8 (2024), the Tax Court held Section 385(c), which generally binds a taxpayer to its initial characterization of an investment as either debt or equity, did not apply to cash advances where no formal instruments had been issued. This case may have implications for corporations with undocumented related party advances.

Determining Debt or Equity Treatment for Tax Purposes

Determining whether an interest in a corporation is debt or equity is a fact-intensive inquiry. Courts have traditionally applied multi-factor tests that look at the intent and relationship of the parties, the financial condition of the corporation, and each party’s legal and economic rights. As these factors are weighted in each case, and the form or name of the instrument is not necessarily determinative of its treatment, taxpayers face uncertainty as to whether the IRS would agree with their chosen characterization. 

In addition, Section 385(c) binds taxpayers to their characterization of an interest in a corporation once a position is taken. The IRS, on the other hand, is not bound by the taxpayer’s characterization and has the ability to reclassify an instrument from debt to equity, and vice versa. As a result, taxpayers are typically well-advised to perform a detailed assessment to determine the correct treatment before reporting a position on a return. In practice, however, this does not always occur, and later discovery that an instrument’s treatment may be questionable often results in taxpayers’ performing this assessment after the fact, thereby potentially triggering the application of the Section 385(c) rules. 

Estate of Fry v. Commissioner

Facts of the Case

Mr. Fry was the sole shareholder of two S corporations, Crown and CR Maintenance. CR Maintenance encountered financial difficulties, and Crown provided financial assistance that allowed CR Maintenance to continue operations. In particular, Crown transferred money directly to CR Maintenance and paid bills on CR Maintenance’s behalf. The amounts were accounted for as loans on both party’s general ledgers and tax returns but were not otherwise documented. CR Maintenance did not claim interest deductions and Crown did not report interest income related to the amounts. In a dispute concerning Mr. Fry’s basis in his CR Maintenance stock, Mr. Fry argued that these transactions should not be considered debt but, instead, should be treated as constructive equity contributions and distributions. The Service disagreed with Mr. Fry, asserting that Section 385(c) precluded him from recharacterizing the transactions as equity contributions.

Tax Court Holdings

In its memorandum opinion, the Tax Court held that Section 385(c) did not apply in this case because there was “no formal issuance of any instrument evidencing the creation of an interest in stock or equity.” In addition, the Tax Court suggested that Section 385 might not apply to S corporations based on the exclusion of S corporations from the regulations promulgated under Section 385(a) in 2016. 

After rejecting the Service’s argument that Section 385(c) precluded Mr. Fry from recharacterizing the transfers of cash between the two S corporations as equity contributions, the Tax Court held that the transfers and payments more likely than not failed to constitute debt based on an analysis using traditional debt-equity factors. The court then determined that the transfers and payments primarily benefited Mr. Fry and, as a result, held they should be considered deemed distributions to Mr. Fry and subsequent contributions to CR Maintenance. 

BDO Insights

The opinion in Estate of Fry potentially creates more questions than it answers. Memorandum opinions are typically reserved for cases that involve settled legal principles. This case being issued as a memorandum opinion is at odds with the language of the opinion itself, which notes that no court has ever applied Section 385(c)(1). In addition, memorandum opinions are not binding on the Tax Court, although they can be used as persuasive authority.

Although the case appears to limit the application of Section 385(c) where no formal notes or stock instruments are issued, the broader implications of the ruling and its reasoning are unclear. In non-precedential guidance, the Service has inconsistently applied Section 385(c) in circumstances where the issuer reports an instrument on its tax return differently from the label given to the legal documents. The Service has also indicated that Section 385(c)(1) precludes a taxpayer from arguing that undocumented cash transfers were equity transactions when the transfers were reported as loans on the taxpayer’s books, records, and tax return balance sheets. This guidance has created confusion for taxpayers that record transfers of cash, which are often made for exigent operational needs, before analyzing whether the transfer is more properly considered debt or equity and before formal documentation (if any) is issued. In Estate of Fry, however, the Tax Court appears to shed some light on what actions constitute a characterization for purposes of Section 385(c). In particular, where there has been no formal issuance of an instrument that purports to be either debt or equity, the application of Section 385(c) may be precluded.

Undocumented related party advances are not uncommon. Although the exact implications are as yet unclear, the Tax Court’s memorandum opinion in Estate of Fry may support the proposition that related party advances are not characterized as either debt or equity for purposes of Section 385(c) unless there has been a formal issuance of an instrument that purports to be either debt or equity, even if the taxpayer has reported the transaction as debt or equity on its books, records, or tax return balance sheets. However, taxpayers should exercise caution in attempting to rely on Estate of Fry in cases that involve distinguishable fact patterns (for example, if one party to the cash transfer accrues or deducts interest on the advance), due to the lack of reasoning in support of the Tax Court’s holding regarding Section 385(c) and the limited precedential value inherent in a memorandum opinion.