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Friday, February 28, 2003


Delta Plastics, Inc. was formed by seven shareholders who had a total equity investment of $183,500. Six of them and the other one�s father also had debenture funds in Delta totaling $1,337,500 in not exactly but roughly equivalent proportions to their equity shares. Delta also received $2,169,013 in secured loans from three unrelated creditors and a $153,825 secured from the primary shareholder, who held 47.96% of the equity and 51.35% of the unsecured debentures. The total debt to equity ratio at start-up was approximately 26 to 1 (or 25:1; the opinion gives two different figures). So of course, this case involves the IRS trying to recharacterize deducted interest payments as nondeductible dividends.

Delta won. In the fact based analysis the only factor that weighed against Delta was the roughly equivalent proportions of debt to equity among the shareholders. In favor of Delta, Tax Court noted that Delta made all of the equity payments as scheduled, the total debt to equity ratio dropped to about 4 to 1 in just over three years, and the shareholders� experience in the trade made them likely aware of the potential success of the company. Tax Court also said that the third party loans were evidence of Delta�s credit worthiness, and the shareholders� testimony as to their intent was credible.

I am unconvinced. Crediting Delta for making scheduled equity payments and quickly reducing its debt to equity ratio, as well as crediting the shareholders with experienced foresight, seems to merely be rewarding Delta for the lucky success of starting up in the economic growth years of 1993 to 1996. Simply rewarding a company for its success seems backwards. It makes it difficult for the IRS to collect taxes from wealthy companies, while potentially forcing struggling companies to go under by denying legitimate deductions. And while Tax Court had good authority for treating making scheduled payments timely in favor of Delta, its authority regarding adequate capitalization only stated that no specific debt to equity ratio is determinative, but said nothing about the effect of later reductions in the ratio or the ability of the shareholder to divine the success of the company. The authority Tax Court provides for the effect of third party loans indicates that having available credit from outside sources is weighed in favor of upholding the treatment of funds as debt. But they provide no authority as to the effect of actual loans, which would seem to use up available credit. And I am scientifically skeptical of the ability of judges (or lawyers and accountants, for that matter) to accurately evaluate credibility based on a subjective observation of testimony. I am more impressed by the fact that the primary shareholder did not give Delta either an entirely secured or entirely unsecured loan, but rater broke up his loan in such a way as to maintain a comparable proportion of debentures to equity among the shareholders.

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