Question

1.C is “owed” $100,000 by the equal AB partnership. C’s note indicates that the interest rate will vary depending on the performance of the partnership, and the note can be rolled over indefinitely as long as the partnership wishes it to be rolled over. The note is subordinated to any other liabilities of the partnership, except that it is secured by property with a current value of $120,000. A and B’s capital accounts total $2,000, and the terms of the note allow C to have a say in certain business decisions of the partnership. The partnership is in the real estate rental business, and its properties are rented virtually 100% of the time. At the current time, C’s debt is the only debt the partnership has. What factors indicate that the note is debt, and what indicate that it is equity? Which should it be classified as?

Answer 1

Factors indicating the “Note” as Debt

A note may be labeled as debit when an instrument contains a written unconditional promise to pay the sum of money on demand with fixed rate of interest. Although there are following factors that distinguish debt from equity:

1. Instrument bearing interest rate repayable on demand or at specified date without converting it into equity,
2. Fixed maturity dates
3. Not able to participate in management directly or indirectly
4. Debt generally secured by movable or immovable property
5. In case of liquidation, debt are repaid thereafter equity

While the following factors that indicates that note can be classified as “equity”

1. An instrument that allows interest payments to be primarily dependent upon the availability of future earning is more likely to be considered equity
2. Repayment due dates not fixed by agreement and seek any extension that shows lack of concern in making repayments in time suggest the instrument as equity characteristics
3. The equity classification would seem more likely if an instrument provides the ability to participate in management.
4. Advance subordinates to other debt indicates that an instrument represent equity

Facts of the Case:

Mr. C has given loan to partnership firm of $100,000 bearing interest rate that will depend upon the performance of partnership and the note can be rolled over indefinitely. Note is sub-ordinate to other liabilities of partnership but it is secured by property having value of $120,000. C can participate in certain decision of the partnership.

As per above facts of the case and analyzing the characteristics or factors that indicates the Note as debt or equity we can classify it as “equity” due to following reasons:

1. Interest rate depend upon the future earnings of the partnership firm
2. No fixed maturity date and can be rolled over indefinitely
3. Mr. C can participate in decisions of the firm
4. Note is subordinated to any other liabilities of partnership that means it will be repaid as equity at the time of liquidation