Section 385 is not just an inversion problem

The short version for anyone running a small multi-entity structure: if you have intercompany loans between commonly-owned entities and the aggregate debt crosses a modest threshold, you are inside the proposal as written. The compliance work, not the tax, is the cost.

What section 385 actually does

Section 385 has been on the books since 1969. Congress gave Treasury authority to write regulations distinguishing debt from equity for federal tax purposes, and for forty-seven years Treasury declined to use it. The statute lists five factors a regulation may consider — written unconditional promise to pay, subordination, debt-to-equity ratio, convertibility, and the relationship between holdings of stock and holdings of the purported debt — and leaves almost everything else to Treasury's discretion. Courts developed their own multi-factor tests in the vacuum. The April proposal is the first serious attempt to fill it.

The proposal does three things. It creates a documentation requirement: certain related-party debt has to be supported by contemporaneous written evidence of an unconditional obligation to pay, creditor's rights, reasonable expectation of repayment, and ongoing behavior consistent with a debtor-creditor relationship. Miss the documentation and the instrument is treated as stock. Second, it contains per se recharacterization rules aimed at specific transactions that look like earnings-stripping — distributions of debt to related parties, debt issued to fund a distribution or an acquisition of related-party stock, and similar patterns inside a 72-month window. Third, it authorizes the Commissioner to bifurcate a single instrument into part debt and part equity, which the common-law tests generally did not allow.

The trigger for all of this is the collapse of the anti-inversion legislative effort and the rise of the earnings-stripping transaction that replaced it. A US subsidiary of a foreign parent borrows from that parent, deducts the interest against US income, and pays interest overseas where it is taxed lightly or not at all. Treasury could not get Congress to act, so Treasury reached for section 385.

Why the small-cap reader should care

The proposal is not limited to inversions or to cross-border structures. As written, it applies to any "expanded group" — broadly, an affiliated group under section 1504 using a 80%-by-vote-or-value test, which captures many closely-held multi-entity families. Brother-sister entities owned by the same individual, a holding company over two operating LLCs taxed as corporations, a management company lending to a portfolio entity: all potentially covered.

The documentation rule is the piece most likely to bite. It requires four items of written evidence, prepared within 30 days of the debt arising (or in some cases 120 days), and maintained for the life of the instrument: the unconditional obligation, creditor's rights on default, a reasonable expectation of repayment based on the borrower's financials at issuance, and ongoing conduct consistent with debt — actual interest payments, responses to default, the things a real creditor would do. None of this is exotic, and a well-run group already does most of it. The novelty is that failure to document is itself the recharacterization. You do not get to argue in court that the instrument was debt in substance. No timely paperwork, no debt.

The per se rules are narrower but sharper. If a subsidiary distributes a note to its parent, or issues a note to a related party to fund a distribution or an acquisition of affiliate stock, the note is treated as stock from issuance — regardless of economics, regardless of documentation. The 72-month presumption is rebuttable in theory and unforgiving in practice: any covered transaction within three years before or three years after a suspect distribution gets pulled in.

There are carveouts. The proposal excludes indebtedness between members of a consolidated group, which takes most US-only corporate affiliated groups out of the per se rules (though not out of the documentation rules, which apply at the expanded-group level). There is an exception where the aggregate issuance of covered debt across the expanded group stays under $50 million, which is meaningful for genuinely small groups but not for anyone with real operating leverage. S corporations and non-controlled partnerships sit outside the expanded-group definition entirely. LLCs taxed as disregarded entities or partnerships are, for this purpose, not corporations and not directly in scope — though a corporate member of such a partnership can be.

What is not yet clear

The comment period closed July 7. Treasury held a public hearing three days later, and the tax bar used both to argue that the rules are overbroad in nearly every direction. By October, the Secretary has said publicly that the final package will narrow the scope and that some proposals will be withdrawn; he has not said which. The candidates for softening are familiar to anyone following the comment letters: raise the $50 million threshold or make it per-issuer rather than aggregate; exempt cash-management and working-capital pools; restore the ordinary substance-over-form defense against the documentation rule; shorten or eliminate the 72-month presumption; defer the effective date.

The harder question is retroactivity. The proposal was written to apply to debt issued on or after April 4, 2016, the day of publication. That is an aggressive posture for rules this consequential, and commenters have argued, correctly, that issuers had no way to comply with documentation rules that did not yet exist on April 4. A prospective effective date tied to publication of the final rules is the more likely outcome. It is not guaranteed.

Nor is it clear what happens to the bifurcation authority. The ability to split a single instrument into part debt and part equity is a large grant of discretion to examiners, and the practical question — when will the Service actually use it? — has no answer yet. The proposal is silent on enforcement posture. History with similar tools suggests slow uptake followed by a handful of signal cases.

What to do before the final rules drop

If you run a closely-held group with intercompany balances, the sensible move this quarter is to pretend the documentation rule is already in force and paper what you have. Get written notes in place for intercompany loans. Put interest rates, payment schedules, and default remedies on paper. Keep a file of the borrower's financial position at issuance. Run interest accruals through the books and actually pay them. None of this is new advice; it is the advice every tax lawyer has been giving for decades to clients who run related-party loans on a handshake. The proposed regulations raise the cost of ignoring it.

The groups that should be paying attention now, before the final rules, are the ones whose structures would fail the documentation test today and whose aggregate intercompany debt exceeds $50 million. The groups that can largely ignore this are the ones that sit entirely inside a single consolidated return or entirely inside flow-through entities. Most readers are in one of those two buckets. The middle case — an individual owner with two or three C-corp subsidiaries and meaningful intercompany loans — is the one where the proposal, as written, does real work.

What remains unresolved is whether the final rules treat that middle case as a problem worth solving or as collateral damage Treasury is willing to walk back.