Very often during the valuation process you’ll come across a shareholder loan recorded on the books of the subject business. Your first impulse will be to determine its fair market value, but wait a minute. The question must be asked: “Is this a bona fide loan or is it really equity?” The trouble is, there is no straightforward answer; and yet a reclassification of debt to capital could have a multi-million-dollar impact on total value.

Nebulous guidance: A bright-line test for debt versus equity simply does not currently exist, according to Christine Baker (Meyers, Harrison & Pia LLC). Speaking at a recent webinar, Baker pointed out that valuation literature is “very general and sort of nebulous without any clear guidance” on this issue. In terms of the courts, family law courts around the country “have not voiced their views on this topic to date.” So where do we look?

Experts in the legal field have directed us toward case law in bankruptcy and Tax Court opinions. A sampling of cases includes Fin Hay Realty Co. v. United States (398 F.2d. 694 (3d Cir. 1968)), in which the Tax Court applied 16 factors to determine the nature of an advance from the shareholder to the business and consequently whether it was debt or equity. Similarly, in the case AutoStyle Plastics, Inc. (269 F.3d 726, 45 U.C.C. Rep.Serv. 2d 964, 2001 FED App. 0378P (6th Cir. 2001), the bankruptcy court outlined an 11-factor test (based on factors originally used in Roth Steel Tube Co. v. Commissioner, 800 F.2d 625,630 (6th Cir. 1986), to recharacterize tax claims) to determine whether an advance was debt or equity.

Consider this: The resolution of a debt-versus-equity issue is like searching for a result along a continuum, which has at one end debt and at the other end equity. Baker advises that in some cases the valuation expert may wish to consider treating a nonperforming “loan” as a preferred equity interest. In other circumstances, a practical step may be to present counsel with two valuation scenarios: One in which the valuation conclusion assumes the loan is not a bona fide debt of the company and another in which the valuation conclusion assumes the loan is legitimate and is to be included (at its fair market value) in the overall determination of the parties’ net worth. These are several alternatives that may assist the parties and their respective counsel in negotiating an equitable settlement.

For an archived version of Baker’s webinar, Valuing Shareholder Loans in Divorce, click here (purchase required).

By: Kim Onisko, CPA