By Rob Sanders, CFA, CFE
Companies control and benefit from assets. The assets are financed through advances of debt (borrowing) or equity (owner contributions). 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). 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.
|1||The names given to the certificates evidencing the indebtedness|
|2||The presence or absence of a fixed maturity date|
|3||The source of payments|
|4||The right to enforce payment of principal and interest|
|5||Participation in management flowing as a result|
|6||The status of the contribution in relation to regular corporate creditors|
|7||The intent of the parties|
|8||“Thin” or adequate capitalization|
|9||Identity of interest between creditor and stockholder|
|10||Source of interest payments|
|11||The ability of the corporation to obtain loans from outside lending institutions|
|12||The extent to which the advance was used to acquire capital assets|
|13||The failure of the debtor to repay on the due date or to seek a postponement|
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.
|1||Names||Issuance of a bond, debenture, promissory note||Stock certificate, lack of any certificate|
|2||Fixed maturity date||Re-payment required (or expressly contemplated) on a fixed date||No fixed date|
|3||Source of repayments||Repaid through more debt||Repaid from retained corporate earnings|
|4||Right to enforce payment||Legal obligation to repay||Discretion whether to repay|
|5||Participation in management||No increase in participation||Increase in participation or voting|
|6||Priority compared to regular corporate creditors||Liens, contractual priority||No priority|
|7||Intent of the parties||If objective intent is unclear, consider if subjective intent indicates debt||If objective intent is unclear, consider if subjective intent indicates equity|
|8||“Thin” or adequate capitalization||Other sources of cash available||High debt-to-equity-ratio, funds used to start up business|
|9||Identity of interest between creditor and stockholder||Advances by stockholders are sharply disproportionate from stock ownership||Advances by stockholders in proportion to stock ownership|
|10||Source of interest payments||Parties agree to provision for payment of interest on the advance||No insistence on interest payments|
|11||Ability to borrow from outside lenders||Reasonable outside lenders would provide loan funding||No reasonable possibility of outside lender money|
|12||Acquire capital assets||Funds used for temporary purposes with reasonably determinable time period||Capital investment made lacking assurance of repayment|
|13||Failure of the debtor to repay or postpone||Repayment made or extension agreed to prior to maturity date||Repayment date passes with no communication|
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.
 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.
 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).”