The Debt Versus Equity Debacle: A Proposal for Federal Tax Treatment of Corporate Cash Advances

much litigation has turned on the issue of whether a cash advance from the shareholders of a closely-held corporation to the corporation itself should be characterized as debt or equity for the corporation’s federal income tax purposes. 2 For instance, Corporation XYZ is formed by Shareholders A and B, who are individuals each owning 50 percent of issued common stock. Immediately after the formation of the corporation, Shareholders A and B advance cash to the corporation for which they receive promissory notes. Here, the issue is whether the cash advance should be characterized as debt or equity for Corporation XYZ’s federal income tax purposes. These hypothetical facts mirror the facts of the Third Circuit’s 1968 leading case, Fin Hay Realty Co. v. United States. 3 Importantly, Fin Hay Realty listed sixteen factors—many of which courts use—to determine whether such a cash advance is debt or equity. 4 One factor considered is