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Borrowing from the Business

A New IRS Audit Technique Guide provides insight and pinpoints problems to avoid when making shareholder loans.  The test for deciding if a disbursement to a shareholder is a loan is whether, at the time it was made, the shareholder intended to repay it and the corporation intended to require repayment. However, it is not enough for the shareholder and an officer of the corporation to testify that they each had the requisite intent. This intent must be shown by objective facts. Following are ten factors that agents may consider in deciding whether withdrawals are loans, compensation or dividend distributions.

1.      Does the shareholder control the corporation?  The probability of an arm's length transaction is far greater if the shareholder receiving the loan does not own a majority (directly or through attribution) of the corporate stock.

2.      Was security given?  The failure to provide security may be an indication that a distribution was intended.

3.      Was the shareholder in a position to repay the loan?  The shareholder's salary, other income, and net worth are relevant in determining the shareholder's ability to repay.

4.      Does the Corporation have adequate earnings and profits?  The fact that a corporation has a deficit or no E&P, doesn't mean that a distribution is a bona fide loan. It simply means that the distribution cannot be classified as a dividend, but could be a return of capital or capital gain.

5.      Is a certificate of debt or other written evidence given to the corporation? The lack of a note is not a determinative factor but the lack of written documentation speaks against a true debtor/creditor relationship.

6.      Is there a repayment schedule or an attempt to repay?  Even if repayments are made, additional advances over a sustained period in excess of repayments would tend to support constructive dividend treatment. 

7.      Is there a set maturity date?  In the absence of a fixed maturity date, a loan will be respected as such if it is repaid within a reasonable period of time. However, constructive dividend treatment may be indicated where an examination reveals that a shareholder annually reissues a term note for the previous amount owed, plus some or all of the accrued interest.

8.      Does the corporation charge interest?  Generally, a failure to charge interest supports a finding that there is a constructive dividend or that there are imputed dividends under the below market interest rules of  Code Sec. 7872.  

9.      Magnitude of the advances.  Large advances to a controlling shareholder where his ability to repay is essentially contingent on future events is an indication of a constructive dividend.  

10.  Dividend history of the corporation. Adequate earnings and profits with respect to the advances made, coupled with no history of paying dividends, favors constructive dividend treatment. 

The above 10 factors must be viewed as a whole and the list is not all-inclusive.  If the entity making the advances is an S corporation and the initial determination is that a debt is bona fide using the above factors, examining agents are told to consider whether the S corporation reasonably compensated the shareholder who received the advances. If not, agents may evaluate whether all or part of the advances should be reclassified as compensation, subject to employment taxes.

In summary, stockholders looking to their corporations for financing should review the above list, document their intent to repay and then follow through with their intent in order to avoid unintended and potentially costly tax consequences.

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