IRS issues final debt-equity regulations

Tax Hot Topics newsletter The IRS issued final regulations (TD 9897) under Section 385 on May 13 that adopt 2016 proposed regulations without substantive change.

Generally, Section 385 provides rules for determining whether an interest in a corporation should be treated as stock or indebtedness. The “distribution regulations” under Section 385 treat certain indebtedness as stock that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result. The final regulations contain rules regarding the treatment of certain qualified short-term debt instruments, transactions involving controlled partnerships and transactions involving consolidated groups under the distribution regulations.

It is important to note that the final regulations do not change the general rules of the “distribution regulations” contained in Treas. Reg. Sec. 1.385-3, which were released as final regulations in 2016. Rather, the finalized regulations provide limited exceptions (and other coordinating rules) that were released concurrently to the 2016 final regulations as temporary and proposed regulations. Specifically, the new final regulations contain exceptions for short-term debt funding arrangements, ordinary course loans and deposits with a cash pool header, among other exceptions generally aimed at exempting debt generated through routine business operation.

Following the expiration of the temporary regulations in October, the IRS issued an advanced notice of proposed rulemaking which included guidance previously provided in Notice 2019-58 allowing taxpayers to rely on the 2016 proposed regulations. The regulations recently issued finalize those proposed regulations. This development provides helpful certainty to taxpayers relying on the proposed regulations.

The IRS also announced in the advanced notice of proposed rulemaking that it plans to conduct a more robust review of the final Section 385 regulations. Specifically, the IRS’s intent is to promulgate “more streamlined and targeted” recast rules that would substantially modify the funding rule, including potentially eliminating the per se nature of the rule. However, the IRS is still undertaking its review of the regulations. For more details on the advanced notice of proposed rulemaking, see our prior coverage.

David Sites
Washington National Tax Office
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David Zaiken
Managing Director
Washington National Tax Office
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Cory Perry
Senior Manager
Washington National Tax Office
T +1 202 521 1509

Yasmin Dirks
Washington National Tax Office
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Mike Del Medico
Washington National Tax Office
T +1 202 521 1522

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