With year-end in sight, many business owners are closing the books and taking distributions from their companies. And with that comes the annual temptation to evade taxes through the use of the so-called “shareholder loans.”
From the outset, I want to note that there is nothing illegal with owners borrowing money from their companies. The problems arise when the IRS questions whether the flow of money was really a loan. When the IRS does ask, most local business owners and their accountants will point to Quickbooks entries coding certain distributions as “loans to shareholders.” But that is woefully insufficient. Coupled with no repayment history, these distributions quickly begin to look problematic.
I will begin with the basics. Typically, a distribution to a shareholder by a C-corporation or an S-Corporation is taxable. If a company has earnings and profits (a concept analogous to retained earnings), then any distribution is taxable as dividends unless the distribution is treated as a loan. If a company has no earnings and profits, then the distribution is non-taxable to the extent of capital contributions. The amount of the distribution in excess of capital contributions is, once again, taxable as a capital gain unless the distribution is treated as a loan. As most business owners do not put a lot of money into their companies as capital contributions, any distribution is typically taxable as either a dividend or a capital gain. The only way to avoid this treatment is to treat the distributions as loans to shareholders.
What makes something a loan? The IRS says the following: “A loan by a corporation to a corporate officer should include the characteristics of a loan made at arm’s length. That is, there should be a contract with a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay the loan. Collateral would also be an indication of a loan.” The courts add a few other factors, such as company’s intent in making the loan, ability to repay the loan, and actual repayment of the loans. But one does not need to know these rules as most businesses routinely borrow money from financial institutions and so they “know” what a loan document looks like. Based on professional experience, it is apparent to me that most local business owners would fail this test because, as noted above, a simple entry in Quickbooks is not sufficient.
What are the consequences of mischaracterizing a distribution as a loan? First, the distribution is now taxable either as a dividend or as a capital gain. Second, the company is treated as if it received interest income from you during all the years that the “loan” was outstanding; interest income that is now taxable. So now taxes have been underpaid at two levels. Whether the use of this technique rises to the level of a criminal conduct or remains a purely civil matter is beyond the scope of this article. Suffice it to say, numerous taxpayers have been charged and convicted for improper characterization of such distributions.
What should a business owner do? An immediate – and a very wrong – reaction is to write off the loan. In such circumstances, the IRS will take the view that the loan was legitimate and that the write-off constitutes a taxable forgiveness-of-debt income. The taxpayer is then left arguing that what it called a loan on prior tax returns was not a loan after all. One need not be a lawyer to understand that judges tend not to reward such taxpayers.
The proper way to handle this problem, if it had already arisen, is to properly document the loan. This means drafting (a) a corporate resolution approving the loan, and (b) a promissory note with a stated interest rate, a specified length of time for repayment, a repayment schedule, and a consequence of non-repayment. The resolution and the promissory note should acknowledge the passing of time and add the unpaid interest to the principal balance to be repaid. Stated differently, the transaction should look like the one a borrower would have with a bank.
A slight variation on this problem exists when a business owner sends money from one business s/he owns to another. These transfers are routinely recorded in Quickbooks as “intercompany loans.” But are they? Absent any indicators of a true loan discussed above, the courts will treat the transfer as follows: Company A makes a taxable distribution to the owner, who then makes a capital contribution or a loan to Company B.
The moral of this story is deceptively simple. If an owner wants the distribution to be a non-taxable loan, it needs to be an actual loan. And should such an owner wonder what is a loan, s/he only needs to think about whether any bank would give money to anybody with no promissory note, no interest rate, and no repayment schedule.