Of the many financial decisions a business faces in its life cycle, one of the most frequent (and certainly most important) is how best to fuel continued growth: should the business issue new debt or new equity? Debt and equity instruments can yield very different outcomes from a tax planning perspective, and so advisors consider a number of factors in determining what instruments to use. Once the “debt or equity” decision has been made, the instrument must be structured so that it is categorized appropriately for tax purposes. To do this, tax planners consider the terms of the relevant instrument in light of a variety of factors set forth in case law and legislative authority. The significant majority of existing authority, however, concerns debt or equity instruments issued by a corporate entity. Increasingly, businesses are operated through partnerships or other pass-through entities, and the question addressed in our recent article becomes whether the test for debt or equity is different in a partnership.
In most cases where equity is desired, it will be clear that holding a partnership instrument denominated as equity is sufficient to make the holder a “partner” for tax purposes. This analysis gets blurry, however, when considering the use of blended arrangements such as equity that has a lot of debt-like features (debt-like equity) or debt with many equity-like features (equity-like debt). In these instances of “blended” equity and debt, the determination of partner status becomes more difficult, as does any analysis of the tax implications of the instrument.
There have been recent court cases that attempt to clarify the how the classification of debt and equity might apply in the context of partnership issuers. The factors and analyses set forth in historical case law (even cases that specifically consider partnerships), however, do not cleanly apply to the complicated debt-like equity.
For example, in the 1960s, the Tax Court held in Hambuechen v. Commissioner of Internal Revenue that the traditional debt-equity tests used for corporations also applied to partnerships. The analysis in Hambuechen did not sufficiently address the complexities in partnership structures (or the types of “blended” instruments discussed above), however, and in subsequent years courts attempted to clarify the debt-equity analysis in light of the many different structures used by taxpayers.
Ultimately, the best structure for any business (and the preferred method of raising capital and fueling new growth) will depend on the applicable facts. Given the many different nuances between equity-like debt and debt-like equity, it is essential to consider the business’s short- and long-term financial goals in close consultation with a team of skilled financial, tax and legal advisors.
It is important to ask the question whether debt is different in a partnership. The short answer is clearly “no,” if you have something that is debt for a corporation it is also debt in a partnership. The longer answer is that the question of debt is integrally tied into the question of what is equity, as most believe you must be either debt or equity (since there are not tax rules governing an “other” category). This debt-like equity complexity is particularly true in partnerships, in part because the analysis of what qualifies as “equity” in a partnership is more difficult (and significantly more restrictive) than in a corporate setting. For now, each situation (and each instrument) must be evaluated on an individual, “facts and circumstances” basis. It remains to be seen whether there will be regulatory or legislative guidance on this issue.