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Tax Deductibility of Loans to Close Corporations: Fin-Hay Realty Co. v. U.S.

In the case of Fin-Hay Realty Co. v. U.S., the court addressed the issue of whether advances made by shareholders to a close corporation, classified as loans, could be treated as debt for tax deduction purposes. The IRS argued that these advances should be considered capital contributions due to the lack of a true debtor-creditor relationship. The court held that because the nature of the transactions did not reflect true loans, the interest payments were not deductible. This ruling emphasizes the importance of distinguishing between debt and equity in taxation.

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Tax Deductibility of Loans to Close Corporations: Fin-Hay Realty Co. v. U.S.

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  1. Fin Hay Realty Co. v. U.S. 398 F.2d 694 (3rd Cir. 1968) Presented by Yi Liang

  2. Justice: Freeman, Van Dusen Citation: Fin Hay Co. v. U.S.,22 AFTR 2d 5004, 398 F.2d 694 (3rd Cir. 1968),68-2 USTC P9438 History:CA-3 and D. Ct. for government • Freedman affirmed district court ruling • Van Dusen enter judgment against U.S.

  3. Facts: • The taxpayer start real estate investments by two shareholders. Each shareholders have an equal share of stock and debt obligations. • Taxpayer claimed that funds entrusted to a corporation in form of loans, thus, interest payments of the loans are deductible on the corporation tax return. • IRS’s position is that advances to a close corporation is capital contribution instead of debt because the real nature of loan transaction did not match its economic reality.

  4. Issue: • When cash contributes to a close corporation by its shareholders in a form of loans and real nature of loan transaction doesn’t match its economic reality, are the corporation’s payment of interest was deductible ?

  5. Holding: • No, when cash contributes to a close corporation by its shareholders in a form of loans, they doesn’t represent a debt, but capital contribution if real nature of loans does not match its economic reality. Thus, the corporation’s payment of interest was not deductible.

  6. Reasoning: • Shareholder’s debt was in the same proportion as their stock ownership • There was no strict debtor-creditor relationship • no retirement provision for the principal; • no set maturity date for the loans; • Real nature of loan transaction does not match its economic reality. • The shareholder’s advance is far more speculative than what an outsider would make; • The corporation needs funds to function; • Loan repayment depends on corporation profits;

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