Closely-held businesses frequently have balance sheet items classified as shareholder loans that represent cash transfers with shareholders. These items may be either assets or liabilities, and often they are carried on the books of the entity for many years with little activity or interest payments. In performing a valuation of the subject company, the valuation practitioner must determine whether these balances are truly debt, or whether they are really equity transactions that were initially characterized as loans.
In order to determine whether the loans represent debt or equity, a “facts and circumstances” approach similar to that taken by the IRS is in order. The Second Circuit set out a widely-used definition of debt in Gilbert v. Commissioner, 248 F.2d 399, 402 (2d Cir. 1957), as follows:
An obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof.
That is, an examination of both the form and economics underlying the transaction should be made, with the economic substance being the more important of the two. See, e.g., Fin Hay Realty Co. v. U.S., 398 F.2d 694, 697 (3d Cir. 1968). The key questions are: Are all parties behaving as if the transaction represents an unconditional obligation to repay the amounts transferred? Would an unrelated lender have entered into a similar agreement?
A number of courts have established lists of factors to consider in making the determination. A 13-factor test was developed in the landmark case Dixie Dairies Corp., 74 T.C. 476 (1980), as follows:
- Name or label of the transaction
- Existence of a fixed maturity date
- Source of payments – whether payments are independent of earnings
- Right to enforce payments
- Participation in management, perhaps as a result of the advances
- Status in relation to outside creditors
- Intent of the parties
- Relationship to equity interests
- Adequacy of equity in the capital structure
- Ability of corporation to obtain credit from outside sources
- Use to which the advances were put
- Failure of the debtor to repay
- Risk involved in making the advances
The foregoing factors are merely to be considered, with no one factor being deemed determinative.
Similarly, the Sixth Circuit has applied an 11-factor test when trying to distinguish between debt and equity, as follows:
- The names given to the instruments, if any, evidencing the indebtedness
- The presence or absence of a fixed maturity date and schedule of payments
- The presence or absence of a fixed rate of interest and interest payments
- The source of repayments
- The adequacy or inadequacy of capitalization
- The identity of interest between the creditor and the stockholder
- The security, if any, for the advances
- The corporation’s ability to obtain financing from outside lending institutions
- The extent to which the advances were subordinated to the claims of outside creditors
- The extent to which the advances were used to acquire capital assets
- The presence or absence of a sinking fund to provide repayments
See Indmar Products, Co., Inc. v. Commissioner [444 F.3d 771 (6th Cir. 2006), rev’g 89 TCM 795 (2005)] and Roth Steel Tube Company v. Commissioner, 800 F.2d 625.
The possible reclassification of shareholder loan balances from debt to equity for valuation purposes adds to the complexity of an engagement. Valuation professionals should be on the lookout for shareholder loan balances early in the process of negotiating the terms of an engagement.