Owners fund closely held businesses with loans as well as equity, and the
characterization matters to lenders, to creditors and to tax.
Debt or equity. Courts and tax authorities examine whether there is a written
note, a fixed maturity, a stated interest rate actually paid, enforcement of
default remedies, subordination to other creditors, the debt-equity ratio,
whether an outside lender would have advanced on the terms, and whether advances
are proportionate to shareholdings. Advances documented as loans but never
repaid and never enforced are recharacterized as capital.
Subordination. Institutional lenders require shareholder debt to be
subordinated, with payment blockage on default and turnover of payments received
in breach. The agreement should specify whether regular interest may be paid
absent default, which is usually the owner’s principal concern.
Equitable subordination in bankruptcy where an insider engaged in
inequitable conduct causing injury to creditors or an unfair advantage;
recharacterization as equity is a separate doctrine applying the debt-equity
factors.
Tax. Interest deductibility, imputed interest where the rate is below
statutory minimums, and the consequences of forgiveness.
Practical discipline. A signed note, a schedule of advances and repayments,
interest accrued and reported, and board approval.
