Owners fund closely held businesses with loans as well as equity, and the characterisation 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 recharacterised 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; recharacterisation 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.