Legal Definitions - recharacterization

Definition: Recharacterization is a court's decision that an insider's loan to a business in liquidation should be treated as a capital contribution instead of a loan. This means that the insider will only receive a portion of the liquidation proceeds after all the business's debts have been paid off. The court considers factors such as the amount of initial capital, the entity's ability to obtain loans from outside sources, and past treatment of similar transactions by the insider.

Example: John is a shareholder in a company that is going through liquidation. He had given the company a loan of $100,000, which he expected to be repaid in full. However, the court recharacterized the loan as a capital contribution, meaning that John would only receive a portion of the liquidation proceeds after all the company's debts had been paid off. This decision was based on the fact that the company had little initial capital, had difficulty obtaining loans from outside sources, and had a history of receiving similar transactions from John.

This example illustrates how recharacterization can affect an insider's expectations of repayment and highlights the factors that a court considers when making this decision.