Let’s face it – whether you fall under the design and construction industry or not, being the owner of a closely-held corporation has its benefits and its challenges. For example, just how many ways are there to get money to and from your corporation and why in the world does it matter how you label those transfers? It’s all your money – isn’t it?
Yes and no
There are various acceptable ways to contribute cash to and withdraw cash from your closely-held corporation. But unless you properly document your intentions and subsequent transactions, the IRS may interpret your actions very differently than you intended. Let’s review the various options.
Money In: Common cash contributions from you to your corporation include the initial equity contribution or purchase of your ownership interest, subsequent paid-in capital contributions to increase your equity in the business and short-term or long-term loans to your corporation to supplement its cash flow needs on occasion.
Money Out: Typical cash distributions from your corporation to you include salaries for services rendered, rent payments for personally-owned property used by the corporation, loan repayments and dividend distributions of corporate profits.
How these transactions are labeled results in very different financial and tax consequences for you and your corporation. Therefore, it is essential to understand how to plan for and structure each transaction so that your overall business and tax objectives can be successfully achieved.
Let’s focus on loans
Although there can be potential negative tax consequences with each of these types of transactions, let’s focus on the issue of loans between shareholders and their corporations. This is an area that is frequently scrutinized by the IRS and is even more frequently handled improperly by small business owners.
Loaning to or borrowing from your closely-held corporation may seem simple, but without proper planning it can be painfully expensive. The IRS often reviews such loans to determine if they’re equity contributions or merely disguised cash withdrawals. In a recent court decision, the Tax Court agreed with the IRS that withdrawals by shareholders from two closely-held corporations were constructive corporate distributions rather than loan proceeds and repayments. As such, the withdrawals triggered taxable dividends and capital gains for the shareholders, rather than non-taxable return of principal, as intended (Knutsen-Rowell Inc.). There have been many cases where the IRS has successfully proven to the courts that the owner of a closely-held corporation received taxable compensation or dividends even though the taxpayer intended for those payments to be nontaxable loan transactions.
What makes it a loan?
What should be considered when transferring funds from your corporation to yourself with the intention of it being treated as a loan? The IRS and courts generally ask the following questions when evaluating a corporation’s loan to one of its shareholders:
• Does the borrowing shareholder control the corporation? The greater the degree of control, the more closely the loan will be scrutinized.
• Do the books and records support the treatment of shareholder advances as debt? For example, if shareholder advances are not described as loans payable on the corporation’s books and as loans receivable in the shareholder’s financial records, the case for treating shareholder advances as debt is weakened.
• Did the shareholder sign a promissory note with an appropriate interest rate, a reasonable repayment schedule and a fixed maturity date or balloon repayment date?
• Has the borrower been making the required payments on schedule?
• Did the corporation require adequate collateral for the loan?
• Is the borrower financially able to repay the loan within a reasonable time period?
• If the borrower missed a payment(s), has the corporation tried to collect?
What have we learned?
The lesson we learn from such court cases and IRS scrutiny is that when a corporation lends money to one or more of its shareholders, the transaction should be structured as though it were being made to an unrelated party – a stranger. The borrower should sign a promissory note that includes payment terms and a final due date. Although fixed maturity dates and repayment schedules are not required for bona fide demand loans (payable at any time upon the demand of the shareholder-lender), the presence of this factor more strongly suggests debt rather than equity. At a minimum, interest should be charged at the IRS statutory rate in effect at the time of the loan. Requiring adequate collateral will also be regarded as a favorable indicator by the IRS, although it is not mandatory. The borrower should make payments according to the agreed upon schedule. And finally, the terms of the loan should be voted on by the board of directors and the details should be documented in the annual corporate minutes.
There is no question that following these guidelines will enhance your chances of prevailing should the IRS decide to scrutinize shareholder loan activity with your corporation. Since circumstances are different for each corporation and shareholder, it’s best to consult your tax advisor before transferring money to or from your company to ensure that the transaction is structured properly to achieve the desired result. Recent history shows us that the cost of cutting corners can be very expensive.
Jan Stockton is the founder of Stockton & Associates P.C., a CPA firm located in downtown Vancouver. She can be reached at 360.695.6511.