Section 385 was added to the Internal Revenue Code more than 40 years ago to provide Treasury with the authority to issue regulations to assist in determining whether an interest in a corporation is to be treated as stock or as debt for tax purposes.

Regulations under §385 that were issued in final form last October (T.D. 9790 (Oct. 21, 2016)) address the classification of related-party debt as debt or equity, and include extensive documentation requirements for certain obligations intended to be treated as debt for tax purposes. Numerous comments were received by the IRS regarding these regulations. A little more than a month ago, these regulations were identified by the IRS, in an interim report, as among eight significant regulation projects that impose undue financial burdens on U.S. taxpayers or add undue complexity (Notice 2017-38, 2017-30 IRB 147). More recently, the effective date of portions of the new §385 regulations that impose documentation requirements was postponed so as to apply only to interests issued or deemed issued on or after Jan. 1, 2019 (Notice 2017-36, 2017-33 IRB __).

Separately, the courts continue to address the distinction between debt and equity by applying factors developed in the many court decisions that have considered this issue in related party and other contexts—which cases, as federal “common law,” will remain relevant even if the regulations issued last year under §385 remain in effect (Reg. §1.385-1(b)). A Tax Court memorandum decision issued in 2015 that addressed these issues in the context of incorporation of a business (Bell v. Commissioner, TC Memo 2015-111), and the recent affirmance of this decision by the U.S. Court of Appeals for the Ninth Circuit in an unpublished opinion (120 AFTR 2d 2017-5152 (9th Cir.)), are discussed below.