Companies control and benefit from assets. The assets are financed through advances of debt (borrowing) or equity (owner contributions).[1] Disputes can arise as to the character of a transaction as debt or equity, requiring a comprehensive analysis to resolve.
Why does it matter whether a transaction is debt or equity? Reasons include differences in tax treatment, priority of claim in bankruptcy, and level of control in the company.
When we are asked to help with the debt or equity determination as analysts, we often look to the seminal case Mixon Estate v. United States (5th Circuit, 1972).[2] In the Mixon Case, the court considered 13 different factors (the “Mixon Factors”), which are listed in the table below. The factors do not all carry equal weight, nor is any single factor controlling.
The analyst considers each of the Mixon Factors as applied to the specific facts and circumstances of the matter. The table below includes some examples.
Ultimately, the analyst must conclude whether debt or equity is indicated based on all the facts and circumstances. The analyst determines debt or equity from an accounting standpoint and does not draw a legal conclusion.
[1] As described in FASB’s Concept Statement No. 8, assets can also be thought of as the present right to an economic benefit, liabilities (including debt) are an obligation to transfer an economic benefit, and equity is the residual ownership. We discussed the value of accounting definitions in a previous post.
[2] As noted in the Mixon Case, the question of debt or equity has been discussed in numerous court opinions and continues to be an ongoing issue because every dispute involves unique facts and circumstances. Courts do not always use the same exact factors but there is substantial overlap in the factors considered. See from Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980), “… e.g., Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) (13 factors); A. R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970) (11 factors); Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968) (16 factors); Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790 (1975) (13 factors).”