Last June, the Internal Revenue Service tried a new regulation to solve the riddle of when a loan is not a loan. But complaints by small business advocacy groups succeeded in delaying the rule's implementation, at least for a while
Under the IRS's proposed rule, the owner of a corporation would not be allowed to lend more than $3 of his own money to the company for each $1 in stock that he holds. Any amount over that would be treated as an equity investment by the IRS, and interest payments would be nondeductible. A long list of other provisions would further restrict tax deductions for interest under a variety of circumstances.
"This rule could be a disaster for a small company like mine," says Dennis Cowhey, president of Computer Insights Inc. of Arlington Heights, Ill., a minicomputer and custom software vendor with about $1 million in annual sales. "This bnsiness is subject to steep peaks and valleys. I need the flexibility to lend money to my company quickly for working capital needs. The three-to-one debt/equity limit could easily be too restrictive " In addition, Cowhey notes, "I personally guarantee some of the company's obligations, and under the rule, these too could become equity in the IRS's eyes."
The regulation falls under Section 385 of the Internal Revenue Code, which Congress passed in 1969 when some conglomerates were issuing huge amounts of debt securities to finance acquisitions, and deducting the interest as a business expense on their tax returns. Thns Uncle Sam, in effect, was helping to foot the bill for the mergers. Congress at that point directed the IRS to specify when interest would be deductible and when it would not. After 13 years of delay and revision, the rule was scheduled to take effect this past June.
"The initial intent of Section 385 was to control actions of large companies, [but] the impact now falls most heavily upon small businesses," says William D. Barth, managing director of Arthur Andersen & Co.'s small business program. "Traditionally, small, closely held companies have relied heavily upon debt as a source of capital. Limiting the amount of debt a company can incur sirnply puts a straitjacket on business capital formation." Barth advocates a number of revisions of the rule, including one to raise the debt/eqnity test for owners to 5:1 from 3:1 and another to exempt companies from the debt/equity test for their first five years in business.
Many small business groups, including the National Association of Small Business Investment Companies and the National Venture Capital Association, campaigned to forestall the regulation. This spring, congressional pressure from Rep Henry Nowak (D-N.Y) and Sen. John Chafee (R-R.I.) helped persuade the IRS to postpone the ruling's effective date in order to further revise and loosen certain sections The Treasury has said that it will issue the new rules in 1983.