Is Debt vs. Equity Different in a Partnership?the fundamental debt-equity principles have changed in the partnership arena

©2015 S.R. SCHNEIDER

By Steven R. Schneider *

STEVEN R. SCHNEIDER is a Member of

the Tax Group at Goulston & Storrs P.C.

and an Adjunct Professor at Georgetown

University Law Center.

Partnership debt versus equity classifi cation is approaching the famed “I’ll know it when I see

it” test. Steven R. Schneider discusses whether the fundamental debt-equity principles have

changed in the partnership arena and how recent authorities should be viewed in the

context of the overall debt-equity framework.

I. Introduction and Overview

To classify an instrument as debt, common law confi rms traditional debt-equity

principles apply to an instrument regardless of the type of entity that issued the

instrument. However, the determination of whether debt-like equity rises to the

level of being a partnership interest is approaching the famed “I’ll know it when

I see it” test. 1 Th e Tax Court in Hambuechen 2 provided a starting point for the

analysis with the conclusion that the traditional corporate debt-equity test also

applies to partnerships. Despite the appealing simplicity and logic of having a

single debt-equity test, partnerships clearly add a level of complexity. For example,

the Hambuechen case did not address the Supreme Court’s Culbertson “totality of

the circumstances” test for determining whether a person rises to the level of a

“partner,” 3 which requires that the parties in good faith and acting with a business

purpose intended to join together in the present conduct of a business enterprise. 4

Th us the question is whether it is axiomatic that a taxpayer holding an instrument

classifi ed as equity in a partnership must be a partner for tax purposes.

Many recent tax-driven cases involved partnership interests with debt-like

economic terms (“Debt-Like Equity”) where the tax planning was dependent

on the interests being treated as partnership equity for tax purposes.

Frequently, the investor’s right to be repaid was bolstered by assets outside

of the partnership that provided additional fi nancial

support. While the issue in these cases was whether

Debt-Like Equity should be respected as equity, much

of the law distinguishing debt and equity arose in a

diff erent context—that is, where a corporation issues

an instrument that was structured as debt for local law

purposes, but had equity-like features (“Equity-Like

Debt”). Th e tilt toward treating an instrument as equity

in Equity-Like Debt cases creates an easier path taxpayers

seeking equity treatment in Debt-Like Equity. Th is

broad defi nition of partnership equity must be balanced

with the Culbertson rule when making the determination

of whether a taxpayer is classifi ed as a partner. To

better understand the current state of aff airs, a brief

legal history is necessary.

of the partnership that provided additional fi nancial

support. While the issue in these cases was whether

Debt-Like Equity should be respected as equity, much

of the law distinguishing debt and equity arose in a

diff erent context—that is, where a corporation issues

an instrument that was structured as debt for local law

purposes, but had equity-like features (“Equity-Like

Debt”). Th e tilt toward treating an instrument as equity

in Equity-Like Debt cases creates an easier path taxpayers

seeking equity treatment in Debt-Like Equity. Th is

broad defi nition of partnership equity must be balanced

with the Culbertson rule when making the determination

of whether a taxpayer is classifi ed as a partner. To

better understand the current state of aff airs, a brief

legal history is necessary.