A Sixth Circuit Judge Just Questioned Whether Bankruptcy Courts Can Recharacterize Insider Loans as Equity, And the Fifth Circuit Is Already on the Other Side

If you own a closely held business and you have ever loaned money to your own company, you should pay attention to In re Insight Terminal Solutions, LLC, 148 F.4th 869 (6th Cir. 2025). The case itself is technical, but the practical point is not. Bankruptcy courts in many parts of the country claim the power to look at a loan from an insider, say, an owner advancing cash to keep the business running, and “recharacterize” that loan as an equity contribution. The consequence is severe: an insider who thought they would be paid back as a creditor instead winds up at the bottom of the bankruptcy waterfall, alongside other equity holders, and frequently recovers nothing.

What Happened in Insight Terminal

In Insight Terminal, the Sixth Circuit decided the appeal on narrow evidentiary grounds. But Judge Eric Murphy wrote a separate concurrence questioning whether federal bankruptcy courts have any authority to recharacterize debt as equity in the first place, an issue he believes only the Supreme Court can resolve. The concurrence is unusual in its directness and could reshape an area of bankruptcy law that has operated under federal multifactor tests for two decades.

The Four Objections to Debt Recharacterization

Judge Murphy raised four core objections.

First, the Bankruptcy Code does not expressly authorize recharacterization. Congress listed nine specific grounds for disallowing claims in 11 U.S.C. § 502(b), and recharacterization is not among them. Where Congress has spelled out a limited list of objections, courts should be cautious about adding more.

Second, the statutory history points the other way. Congress did codify the related doctrine of equitable subordination at 11 U.S.C. § 510(c), but that doctrine requires proof of inequitable conduct. Recharacterization, as currently practiced, requires no such finding, which Judge Murphy treated as evidence that recharacterization is a judicial invention rather than a codified power.

Third, courts cannot lean on the catch-all in 11 U.S.C. § 105(a). The Supreme Court’s recent decision in Harrington v. Purdue Pharma L.P., 603 U.S. 204 (2024), made clear that section 105(a) only allows bankruptcy courts to carry out powers expressly granted elsewhere in the Code; it cannot independently create new ones.

Fourth, the eleven-factor test most circuits use to recharacterize debt, drawn from In re AutoStyle Plastics, Inc., 269 F.3d 726 (6th Cir. 2001), was borrowed from federal tax law, where Congress did expressly authorize Treasury to draw the stock-versus-debt line under 26 U.S.C. § 385. The Bankruptcy Code has no analogous provision, and the Supreme Court has separately held that state law generally governs whether a creditor has a right to payment.

Why the Fifth Circuit Matters Here

For Houston business owners and the lenders who finance them, the most important point is that the Fifth Circuit is already on the side Judge Murphy endorsed. Along with the Ninth Circuit, the Fifth Circuit holds that state law, not a federal multifactor test, governs whether an advance is debt or equity in bankruptcy. See In re Lothian Oil, Inc., 650 F.3d 539 (5th Cir. 2011).

Practical Steps for Closely Held Businesses

If you make loans to your own company, or take loans from owners or affiliates, the documentation discipline you build today determines what happens in a downside scenario. At a minimum, use a written promissory note with a fixed maturity date, a stated interest rate at least equal to the applicable federal rate under section 1274(d), a defined repayment schedule, and remedies on default. Treat the loan as a loan in your books, not as a capital account adjustment, and actually make the scheduled payments, in full and on time. Keep the company adequately capitalized so the loan is not the only thing keeping it afloat. Avoid “loans” whose repayment is contingent on the success of the business; that is the textbook indicator of equity.

If the company already has third-party debt, consider whether the insider advance should be subordinated by written agreement, and price the loan as if a third party would have made it on the same terms.

Why North Star Law Firm Approaches These Cases Differently

Insider lending sits at the intersection of business structuring, federal tax law, and bankruptcy law. The same loan can be characterized differently in each context, with different consequences. My background as a JD/CPA admitted to both the U.S. Tax Court and the U.S. Bankruptcy Court for the Southern District of Texas means we evaluate insider transactions across all three lenses simultaneously, not sequentially as a tax issue, then a corporate issue, then a bankruptcy issue.

Next Steps

If you make insider loans to your own business, or your business takes loans from related parties, the documentation and capitalization discipline you build today determines what happens in a downside scenario. North Star Law Firm advises Houston-area lenders and business owners on transaction structuring, insider lending, and bankruptcy defense.

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North Star Law Firm │ Houston, Texas

Phillip Zagotti, JD/CPA │ 832-384-4526

Frequently asked questions

What is debt recharacterization in bankruptcy?

Debt recharacterization is a doctrine some bankruptcy courts use to reclassify a creditor’s claim from debt to equity. The practical effect is that the holder of the recharacterized claim moves from a creditor position (paid before equity holders) to an equity position (paid only after creditors are made whole, which rarely happens in bankruptcy). The doctrine is most often applied to insider loans, advances from owners, officers, or affiliated entities to the debtor.

What is the difference between recharacterization and equitable subordination?

Equitable subordination, codified at 11 U.S.C. § 510(c), requires proof of inequitable conduct and reorders the priority of an otherwise valid claim. Recharacterization, by contrast, asks whether the claim is really debt at all, if not, it is treated as equity from the start. The two doctrines are related but distinct, and recharacterization is the more aggressive of the two because it does not require any showing of misconduct by the lender.

Does Texas (Fifth Circuit) law allow recharacterization of insider loans?

The Fifth Circuit, in In re Lothian Oil, Inc., 650 F.3d 539 (5th Cir. 2011), held that state law, not a federal multifactor test, governs whether an advance is debt or equity in bankruptcy. That puts the Fifth Circuit on the side of state law, opposite the Third, Fourth, Sixth, and Tenth Circuits. The practical effect for Texas debtors is that documentation, capitalization, and substance under Texas contract and corporate law govern whether an insider loan is respected in bankruptcy.

How can I document an insider loan to defeat a recharacterization argument?

Use a written promissory note with a fixed maturity date, a stated interest rate at least equal to the applicable federal rate under section 1274(d), a defined repayment schedule, and remedies on default. Treat the loan as a loan in your books, not as a capital account adjustment. Actually make the scheduled payments, in full and on time. Maintain adequate company capitalization so the loan is not the only thing keeping the business afloat. Avoid contingent-on-business-success repayment terms.

Will the Supreme Court resolve the circuit split?

Possibly, eventually. Judge Murphy’s concurrence in Insight Terminal is best read as an explicit invitation for the Court to take up the question. The split between the federal-test circuits and the state-law circuits is well-developed, and the Court’s recent decision in Harrington v. Purdue Pharma L.P. limiting reliance on section 105(a) provides a doctrinal hook. Until the Court acts, the law of recharacterization depends entirely on which circuit your case is in.

What factors do courts use under the AutoStyle test?

The eleven AutoStyle factors include the names given to the instruments, the presence of a fixed maturity date and schedule of payments, a fixed interest rate and interest payments, the source of repayments, adequacy or inadequacy of capitalization, identity of interest between creditor and stockholder, security for the advances, the corporation’s ability to obtain financing from outside lending institutions, the extent to which advances were subordinated to outside creditors, the extent to which advances were used to acquire capital assets, and the presence or absence of a sinking fund to provide repayments.

Does the Bankruptcy Code expressly authorize recharacterization?

No. Congress did not include recharacterization in the nine grounds for disallowing claims listed at 11 U.S.C. § 502(b), and there is no other express authorization in the Code. Courts that recognize the doctrine rely on inherent equitable powers, on 11 U.S.C. § 105(a), or on a multifactor test borrowed from federal tax law. Each of those bases is contested, and Judge Murphy’s concurrence in Insight Terminal lays out the case against each.