AICPA to Treasury and IRS: Adopt Recommended Modifications and Delay Effective Date of Section 385 Proposed Regulations

The American Institute of CPAs (AICPA) has recommended to the U.S. Department of the Treasury and the Internal Revenue Service (IRS) a delay in the effective date of Internal Revenue Code section 385 proposed regulations (REG-108060-15) related to the treatment of certain interests in corporations as stock or debt for federal tax purposes, as well as urged that numerous exceptions to the proposed regulations be provided as part of its many technical comments and recommendations.

Currently, there are no regulations in effect under section 385, which was authorized by Congress in 1969, to determine whether an interest in a corporation is to be treated as stock or indebtedness under the Internal Revenue Code.  Instead, the case law that has been used since the enactment of section 385 to characterize an interest in a corporation as debt or equity has continued to evolve. 

Describing the effect of the proposed regulations as “pervasive and novel,” AICPA Tax Executive Committee Chairman Troy K. Lewis wrote in the AICPA’s comment letter that the effective date of the regulations should be deferred until after the proposed regulations are finalized in order to allow companies adequate time to modify their internal controls to comply with the new rules.  Specifically, he wrote, the effective date provision could provide that the provisions apply to any expanded group instrument issued in taxable years beginning one year after the first day of the first taxable year following adoption of the regulations as final.

Lewis stressed that there are many concerns among taxpayers and tax practitioners about the proposed regulations because, if they are finalized in substantially the same format, they “would have a significant and disruptive impact on normal and critical operations of a large number of United States business entities.”  Furthermore, he wrote, “The proposed regulations would also dramatically impact U.S. corporate tax planning and compliance.”

The AICPA’s proposed exceptions and technical comments and recommendations covered a variety of areas, including cash management practices, partnerships and S corporations.

In a separate July 13 comment letter, the AICPA expressed its concerns that the Treasury Department and the IRS do not have the authority to extend the application of the proposed section 385 regulations to partnership equity or debt instruments issued by partnerships.  The letter stated, “The language in section 385 relates directly to Treasury’s authority to prescribe regulations to determine whether an interest in a corporation is considered debt or equity for federal income tax purposes…It does not appear that any regulations issued under this authority apply to partnerships.”