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.