## Facts

- Fin Hay Realty Co. was a closely held New Jersey real estate corporation formed by two shareholders, each contributing $10,000 for stock.
- At formation, each shareholder also advanced $15,000 to the corporation in exchange for unsecured demand notes bearing 6% interest; the funds were used to buy an apartment house.
- About one month later, each shareholder advanced an additional $35,000 on similar 6% unsecured demand notes; the corporation then acquired additional apartment buildings using cash and a purchase-money mortgage.
- Over the next several years, each shareholder advanced additional funds, bringing each shareholder’s total advances to $53,000, separate from their stock investment.
- The corporation’s assets were long-term real estate holdings, it relied heavily on mortgage financing, and it lacked realistic ability to repay the demand notes promptly on demand.
- After one shareholder died, the corporation later refinanced and sold property, then redeemed the decedent’s stock and retired the notes.
- The corporation made periodic payments labeled as “interest” on the shareholder notes and deducted them under I.R.C. § 163(a).
- The IRS disallowed the deductions, treating the advances as capital contributions and the payments as nondeductible distributions, prompting the corporation to seek refunds.

## Issues

1. Whether shareholder advances evidenced by unsecured demand notes in a closely held corporation constituted bona fide debt or equity for federal income tax purposes.
2. Whether payments labeled as “interest” on those notes were deductible under I.R.C. § 163(a) or were nondeductible distributions.

## Decision

- The Third Circuit affirmed judgment for the United States.
- The court held the shareholder advances were equity (capital contributions), not genuine indebtedness.
- Because the advances were equity, the corporation’s claimed “interest” payments were not deductible under I.R.C. § 163(a).

## Legal Principles

- Debt–equity classification for tax purposes turns on substance and objective economic reality, not the formal labels used by related parties.
- In a close corporation where the same persons are shareholders and purported creditors, the transaction receives heightened scrutiny because terms can be set to obtain tax benefits.
- No single factor controls; courts weigh the entire situation, including capitalization, identity of interests, realistic repayment expectations, source of repayment, presence of meaningful creditor safeguards, and whether terms resemble arm’s-length lending.
- Advances that function as risk capital—tied to business fortunes and repayable only through refinancing or asset sales—are likely equity even if documented with promissory notes.

## Conclusion

The Third Circuit treated the shareholder demand-note advances as equity because the arrangements lacked arm’s-length creditor characteristics and repayment depended on the enterprise’s real estate fortunes; accordingly, the corporation could not deduct the payments as interest under I.R.C. § 163(a).


Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968)