Debt or Equity? Surviving the IRS Recharacterization Trap Under Section 385
In the world of corporate finance, the tax difference between debt and equity is binary and massive. Interest paid on a loan is generally tax-deductible for the corporation, while dividends paid on stock are not. For decades, companies have utilized "intercompany loans" to move cash between entities while generating interest deductions. However, the IRS has a powerful weapon in Section 385: the ability to recharacterize a "loan" as "equity" if it doesn\'t look and act like a real debt. If the IRS wins, your interest deductions vanish, and your loan repayments are treated as taxable dividends. Our Corporate Advisory Group specializes in engineering debt instruments that survive Section 385 scrutiny.
The Documentation and Maintenance Standards
The Section 385 regulations impose strict documentation requirements for intercompany debt. To be respected as debt, there must be a written promissory note, a fixed maturity date, and a legally enforceable right to payment.
Furthermore, the "borrower" must have the financial capacity to repay the loan at the time it is issued. If a parent company lends money to a subsidiary that has no cash flow and no assets, the IRS will easily argue the "loan" was actually a capital contribution. We provide the forensic solvency analysis needed to document the subsidiary’s creditworthiness, ensuring that intercompany financing is backed by the same evidentiary trail as a third-party bank loan.
The "Recast" Risk in M&A Transactions
Section 385 risks are often highest during a corporate acquisition. If a buyer uses a mix of debt and equity to fund the purchase, and the debt-to-equity ratio is too aggressive, the IRS may "Recast" the debt as equity.
This is particularly common in Section 338(h)(10) deemed asset sales where the buyer is attempting to maximize interest deductions against the newly stepped-up assets. We perform "Debt-Capacity Modeling" to establish a defensible "Safe Zone" for your leverage ratios based on industry comparables and interest coverage tests. Proper structuring ensures that your capital stack remains tax-efficient throughout the multi-year hold period and survives the inevitable post-acquisition audit.