As a prerequisite to extending surety credit to a construction corporation, surety underwriters are quick to demand the shareholders, who are also creditors, to subordinate to the surety's interests the notes receivable from the construction entity. To comply with this mandate, the noteholder executes a subordination agreement on the surety's form, agreeing neither to accept nor demand repayment without the surety's written consent. Some subordination agreements, usually in the case of long-term notes when scheduled repayment is amortized on a monthly basis exceeding twelve months, permit repayment according to the note's terms. Other agreements, however, allow no repayment of principal, but may permit periodic payment of accrued interest. In any form of insolvency proceedings involving the liquidation of the company's assets, the surety's rights of recovery take precedence over those of the subordinated noteholder. In their zeal to enhance the surety's position, the underwriter may jeopardize the favorable tax treatment otherwise accorded the debt service payments while marginally strengthening the surety's position.

In the typical surety arrangement, the surety requires indemnification from both the construction entity (principal) and its shareholders (personal indeminitors). Consequently, in the event of liquidation, the surety has access to both the principal's corporate assets and the shareholders' personal assets, including the note(s) receivable from the construction corporation. Additionally, in the event of a contractor's default that results in the corporation's liquidation, the surety, generally, must first look to the principal's assets for satisfaction of its claims before the surety can attach the indemnitors' personal assets. Therefore, the subordination agreement forces the corporation to retain cash that otherwise would be used to service the debt. To that end, the corporation's cash position is greater, and this marginal cash would be readily available to satisfy the surety's, as well as other creditors', claims without attaching the indemni-tor's personal assets. Usually, however, the corporate assets, including this marginal cash balance, are not adequate to satisfy the surety's and other creditors' demands in the event of a corporate liquidation precipitated by the contractor's default. Therefore, the surety will still have to pursue the indemnitor's personal assets in its attempt to make itself whole.

To understand the negative tax implications, we first must review the different tax treatment accorded debt and equity, and we must also consider how subordination can adversely effect the instrument's classification for tax purposes. Debt and equity instruments are treated differently from a taxation perspective, particularly in the areas of: 1) current distributions and 2) the recovery of the investment.

CONSEQUENCES OF CURRENT DISTRIBUTIONS

§)163(a) of the Internal Revenue Code allows the payor corporation to deduct, "all interest paid or accrued within the taxable year on indebtedness." No comparable deduction is allowed for dividend distributions¹ to corporate shareholders.² Since these payments are ordinarily taxed to noncorporate recipients in the same way (ordinary income) regardless of whether they constitute interest on debt or distributions on stock, § 163(a) usually encourages the corporation to meet its financing needs by borrowing rather than issuing stock.

The value of the interest deduction is depicted in the following example that compares a corporation's after- tax cost of an interest payment to that of a dividend:

The generalization that corporations prefer to issue debt rather than equity must be qualified for entities in certain special circumstances such as: 1) corporations that are incurring losses and can not use the interest deductions either currently or in the foreseeable future; 2) corporations without earnings and profits 3 ( E & P is an economic concept utilized by the tax law to approximate a corporation's power to make distributions which are more than just a return of investment), whose distributions to shareholders are ordinarily nontaxable returns of capital up to the adjusted basis of their shares; and 3) corporations whose stock is held by other corporations since intercorporate dividends qualify for a 70 %, 80 %, or 100 % deduction under § 243(a) while interest is fully taxable (assuming the creditor is a tax paying entity).

TREATMENT OF INVESTMENT RECOVERY

From the issuing corporation's perspective, the repayment of debt in full at maturity is not a taxable event. The same is true of a stock redemption. This assumes in either case that the issuer does not distribute appreciated property · to effect the transaction, and in the case of debt, there is no unamortized original issue discount or premium.

From the investor's point of view, however, the comparison between debt and equity is more complicated. Ordinarily, shareholders of publicly held companies whose stock is redeemed apply the proceeds against the adjusted basis of the stock and realize capital gain or loss to the extent of any excess or shortfall.⁴ Creditors are similarly entitled to receive repayment of their loans^· tax-free up to the basis of the debt. Since the collection of a debt instrument on retirement is considered to be an exchange,⁵ any gain ordinarily is capital. However, this gain is taxed as ordinary income rather than as capital gain to the extent of any accrued market discount.⁶

The tax treatment of debt and equity diverges much more dramatically in the · case of closely held corporations. These shareholders will be required to report the entire amount received (with no offset for the adjusted basis of the stock) on the redemption of their stock as ordinary income (assuming sufficient E&P to support dividend treatment), unless the redemption completely terminates the shareholder's interest in the corporation or is substantially disproportionate related to the other shareholders.⁷ By contrast, the creditors of closely held corporations, even if they also own stock in the enterprise, are generally taxed in the same manner as creditors of publicly held corporations. That is, they can recover the adjusted basis of the claim tax-free, and they are taxed only to the extent of any excess received. The opportunity for investors in closely held corporations to withdraw their debt investment painlessly rivals the interest deduction in encouraging them to split the investment between debt and equity rather than use an all-stock capital structure.

To recap, the classification of the investment is critical, particularly in closely held corporations for two reasons: 1) if the investment is deemed equity, the corporation is precluded from deducting the current distributions, and 2) if the investment is deemed equity, the investor, generally, will have to treat the return of the investment corpus as ordinary, dividend income (assuming the corporation has adequate E&P to support dividend treatment), unless the shareholder completely terminates his equity holdings or can satisfy the requirements of §302(b)(2). The following example illustrates these negative implications:

If the debt investment is deemed equity, then X will have ordinary, dividend income of $55,000. Since §318 attributes X's family members' (Y&Z) holdings to X, §302(b)(2), ^{"Substantially} Disproportionate Redemption" is not satisfied, because via §318 X still owns 100 % of XYZ's stock. Also, X has not completely terminated his interest in the corporation as required by § 302(b)(3). In X's own right, he still owns $200,000 of stock, and due to §318, X owns $ 300,000 of stock.

Additionally, the corporation's after-tax cost of the debt service payment is $5,000, because dividend payments are not deductible by the payor corporation. If, on the other hand, the IRS acquiesces that the debt investment is in fact debt, then X has only $ 5,000 ordinary interest income, as the $50,000 payment to ret,re the debt is treated as an exchange. Further, the corporation is permitted to deduct the $ 5,000 debt payment. Assuming a 35 % marginal tax rate, the net cost of this interest payment is $3,250.

DEBT OR EQUITY? CLASSIFICATION ISSUES

In attaching different tax consequences to debt as compared with equity, the code necessarily presupposes that these alternative ways of investing in a corporation can be distinguished from one another. However, the code itself does not define the boundary line.

In 1969, Congress enacted §385 which authorized the Treasury Department, of which the IRS is a part, to define "Corporate Stock and Debt" by regulations for all purposes of the code. §385(b) lists five (5) factors that maybe considered in the regulations:

1) Whether there is a written unconditional promise to pay, on demand or on a specified date, a fixed amount of money in return for an adequate consideration and to pay a fixed rate of interest;

2) Whether there is a subordination to, or a preference over, other debt;

3) The ratio of debt to equity of the corporation;

4) Whether there is convertibility of debt into stock of the corporation; and

5) The relationship between stockholdings and holdings of interest in question.

In 1980, the Treasury issued proposed and final regulations (with a delayed effective date that was extended several times). The Treasury then issued new proposed regulations, which were in turn withdrawn in 1983.

In 1989, legislation abandoned the broad definitional approach in favor of narrowly targeted rules aimed at perceived abuses of the interest deduction:

1) the high-yield-original-discount limitations of §163(e)(5):

2) the interest-stripping limitations of §163(j); and

3) the granting of prospective regulatory authority in §385(a) to bifurcate hybrid instruments into part stock and part debt.

In determining whether hybrid securities should be classified as debt or equity, the courts customarily refer to a checklist of relevant items, as indicated from a much cited Third Circuit Court of Appeals decision8:

In attempting to deal with this problem, courts and tax commentators have isolated a number of criteria by which to judge the true nature of an investment which is in the form of debt:

1) The intent of parties;

2) The identity between creditors and shareholders;

3) The extent of participation in management by the holder of the instrument;

4) The ability of the corporation to obtain funds from outside sources;

5) The "thinness" of the capital structure in relation to debt;

6) The risk involved;

7) The formal indicia of the arrangement;

8) The relative position of the obligees as to other creditors;

9) The voting power of the holder of the instrument;

10) The provision of a fixed rate of interest;

11) A contingency on the obligation to repay;

12) The source of the interest payments;

13) The presence or absence of a fixed maturity date;

14) A provision for redemption by the corporation:

15) A provision for redemption at the option of the holder; and

16) The timing of the advance with reference to the organization of the corporation.

With respect to subordination, subordination is an adverse factor. The reason is it tends to wipe out a most significant characteristic of the creditor-debtor relationship. Further, it is practically ah admission that the advances were cor~-sidered equity capital, or it is indicative of equity investment. The courts sometimes play down the significance of subordination when forced on a reluctant corporation by a regulatory agency or institutional lender. However, rather than buttressing the debt status, lender or regulatory imposed subordination maybe evidence that the corporation needed additional equity capital to conduct operations responsibly?

Once a disputed instrument's equity and debt features have been classified, as such, it becomes necessary to determine which is the dominant group. The Supreme Court in Paulsen v. CIR 10 followed the conventional practice' of weighting the relevant features of a hybrid security in determining whether the security's debt or equity characteristics predominate.

Conclusion

In conclusion, subordination by itself may not "tip the scales" in favor of equity treatment. However, given the profile of the typical construction contractor (a closely held corporation with a moderate to high debt to equity ratio), subordination coupled with the relationship between the stockholdings and holdings in the note would certainly invite scrutiny and likely will sound the "death bell" for the desired debt treatment.

Therefore, the surety should thoroughly evaluate its request for subordination in light of the marginally enhanced security position versus the negative tax implications. Otherwise, due to these possible negative cash flow implications associated with subordination, the surety may be "cutting off its noise to spite its face."

A) Out of its earnings and profits accumulated after February 28, 1913; or

B) Out of earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.

2. This fundamental distinction is subject to minor exceptions: For example § 279 disallows interest on debt incurred in certain debt-financed corporate acquisitions; § 247 allows dividends paid on certain ancient preferred stock of public utilities to be deducted; § 404(k) allows deductions for certain dividends to employee stock - ownership plans.

3. § 312 and related Treasury regulations provide guidance into the determinations of Earnings & Profits.

4. §302(a) provides that a redemption of stock shall be treated as a distribution in part or full payment in exchange for the stock if the transaction fits into any one of the following four categories:

A) A redemption that is not essentially equivalent to a dividend under § 302(b)(1);

B) A substantially disproportionate redemption of stock under § 302(b)(2);

C) A redemption of all the shareholder's stock under § 302(b)(3); and

D) A partial liquidation of the distributing corporation under §302(b)(4) ( applicable only if the redeemed shareholder is not a corporation).

Note: Redemptions by public corporations are not exempted per se from the rules of § 302, but their redemptions are likelv to meet the criteria of § 302(b)(1) -- "not essentially equivalent to a dividend."

5. § 1271(a)(1) states that generally amounts received by the holder on retirement of any debt instrument shall be considered as an amount received in exchange therefor.

6. See § 1276.

7. Per § 302(b)(2) to qualify as substantially disproportionate, the redemption must meet three requirements:

A) Immediately after the redemption, the shareholder must own less than 50 % of the total combined voting power of all classes of outstanding stock entitled to vote.

B) The shareholder's percentage of the total outstanding voting stock immediately after the redemption must be less than 80% of the percentage ownership of such stock immediately before the redemption.

C) The shareholder's percentage of outstanding common stock (voting or non voting) after the redemption must be less than 80 % of the shareholder's percentage of ownership before the redemption.

Note: The constructive ownership rules of §318 are applicable in determining whether a redemption is substantially disproportionate under section 302(b)(2) and these rules materially reduce the feasibility of such redemptions by closely held family corporations. § 318(a)(l) states, "an individual shall be considered as owning the stock owned, directly or indirectly, by or for:

(i) his spouse ( other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and

(ii) his children, grandchildren, and parents.''

Fin Hay Realty Co. V. US, 398 F2d 694 (3rd Cir. 1968)

9. Jones v. US, 659 F2d 618( 5th Cir. 1981), surplus capital notes issued by insurance company to satisfy state reserve requirements held debt despite subordination to policyholders' claims. Compare Universal Castings Corp., 37 TC, 107 (1961), afl'd, 303 F2d 620 (7th Cir. 1962), business necessity established that business needed additional equity.

10. Paulsen v. C[R, 469 US 131 (1985)

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