Tax Issues: Corporate loans can be a taxing proposition
The Internal Revenue Service is increasingly scrutinizing loans between corporations and shareholders. Many of these loans are undocumented, don’t call for payments, don’t provide for interest and probably won’t ever be repaid. If this happens to be the scenario for your company, the IRS probably will question whether these really are loans.
The issue is loan repayment. The IRS will always want to argue that it’s a dividend, and not a loan repayment. Why? Because the dividend is taxable to the shareholder, whereas the loan repayment is not.
So the onus is on the taxpayer to prove that this was really a loan. Unfortunately most business owners “lend” money to their corporations without any supporting loan documentation or method of repayment. The IRS would argue that this is the definition of a dividend, since it’s the expectation of profit to pay the “dividend.”
If these “loans” ultimately are reclassified by the government as something other than loans, the tax repercussions can be rather serious. For example:
• If a C corporation makes such a “loan” to a shareholder, the loan can be considered a dividend for which the corporation gets no deduction, while the shareholder is taxed on the full amount of the loan.
• If the shareholder makes a “loan” to a corporation, the loan can be considered a contribution to capital for the corporation and repayment can be considered a distribution of earnings, which is a dividend to the shareholder with no deduction for the corporation.
• If an S corporation makes a “loan” to a shareholder, it can be considered a distribution from the accumulated adjustment account (AAA) up to the limit of that account, then it becomes a return of basis and after that it’s a capital gain.
• If the shareholder is not being adequately compensated, the loan may be reclassified as additional compensation, subject to payroll taxes, along with interest and penalties.
• If the shareholder makes a “loan” to an S corporation, the loan can be reclassified as a second class of stock, which thereby disqualifies the S election.
A case in point:
A business owner puts $100,000 in his corporation that is a “loan” but does nothing to document this. The company has $125,000 in net assets and $575,000 of unsecured debts to suppliers. He then files Chapter 7 bankruptcy. Under this scenario, the owner is out $100,000 because the suppliers would get it.
Unless he makes one simple twist — if he had simply recorded a perfected lien against the corporation, then he would have preferential treatment as a secured creditor, and would be entitled to get his money, the $100,000, with the remaining $25,000 going to the unsecured creditors. This is mostly an issue for C corporations, because we’re always looking for ways to get money out of the corporation and not have to pay taxes on it.
Below are factors most often considered in deciding if the payments between shareholders and corporations really are loans, or if they should be reclassified as dividends or contributions to capital.
• Whether enforceable promissory notes were issued.
• If interest was paid or accrued and if the interest rate reflected the current market rates.
• If the borrower in fact repaid or attempted to repay the advances.
• Whether security was given for the loan.
• The extent to which the shareholder controls the corporation.
• If there existed a set maturity date for the loan.
• The earnings and dividend history of the corporation.
• If the borrower was in a position to repay the advances.
• How large the advances were and does a ceiling exist that limits the loan amount.
• How the shareholder and corporation recorded the loan on their books and records.
The moral: Treat your company’s finances at arm’s length.
Steve Feinberg is a certified public accountant and the owner of a Fiducial franchise in Londonderry, specializing in accounting, payroll and tax planning for small to mid-size businesses. He can be reached at firstname.lastname@example.org or by calling 434-5981.