26 U.S.C. § 385 — Treatment of certain interests in corporations as stock or indebtedness

(a) Authority to prescribe regulations. The Secretary can write rules to decide whether an interest in a corporation should be treated, for tax purposes, as stock, as debt (indebtedness), or partly as each. (b) Factors. Those rules must list the factors used to decide, for a specific situation, whether it's really a debtor-creditor relationship or a corporation-shareholder relationship. The factors can include: (1) whether there's a written, unconditional promise to pay a specific amount of money on demand or by a certain date, in exchange for real value, plus a fixed interest rate; (2) whether the interest ranks behind or ahead of the corporation's other debts; (3) how much debt the corporation has compared to equity; (4) whether the interest can be converted into stock; and (5) whether the people who hold this interest are the same people who hold the corporation's stock. (c) Effect of classification by issuer. (1) When the corporation issues the interest, however it labels the interest — as stock or as debt — that label is binding on the corporation and on everyone who holds that interest. It is not, however, binding on the Secretary. (2) A holder can avoid being bound by that label if the holder discloses, on their own tax return, that they're treating the interest differently — unless regulations say otherwise. (3) The Secretary can require whatever information is needed to enforce this subsection.