In a revision to a recently updated Chief Counsel's Notice (CC-2016-009, "the Notice"), the IRS has expanded the scope of Section 385 debt-equity cases requiring review by the National Office.

The Notice, dated June 30, 2016, alerts IRS attorneys to changes with regard to the list of issues, whether in audit or litigation, that require review by the appropriate Associate Chief Counsel in the IRS National Office. The list includes both general issues (e.g., validity of a regulation, issues of first impression) and specific issues (e.g., Section 385(c) debt-equity issues). The initial changes in the Notice, which will be incorporated into the Chief Counsel's Directives Manual (CCDM), were intended as a general modernization, eliminating items no longer requiring Associate Office review while adding several new items.

"Section 385(c)" as a specific issue requiring National Office Review was retained in the Notice as originally published. In a tweak to the Notice issued in late July, several weeks after initial publication, however, the IRS changed the list item from "Section 385(c) (debt vs. equity)" to "Section 385 (debt vs. equity)."

The more expansive language in the modified Notice incorporates issues under Section 385(a) (authority of the Secretary to issue regulations treating certain interests as stock, debt, or part-stock/part-debt) and 385(b) (factors to be taken into account in determining in a particular situation whether a debtor-creditor or corporation-shareholder relationship exists) — in addition to the issues under 385(c) (effect of classification by issuer) already included. The coordination requirements in the Notice apply to Chief Counsel attorneys, not IRS examiners.

The modification requiring expanded Associate Office review of Section 385 cases follows the issuance in April of new proposed regulations under Section 385 (the Proposed Section 385 Regulations) that would treat certain related-party corporate interests as stock, rather than debt, for federal tax purposes (see Tax Alert 2016-632{}).

Implications

This change strongly suggests that Section 385 debt-equity issues will come under increased IRS scrutiny, particularly in light of the issuance of the Proposed Section 385 Regulations, which are expected to be finalized soon. As such, taxpayers should immediately begin to consider how the Proposed Section 385 Regulations will affect their operations and any ongoing IRS activity, including examinations.

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