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Taxation & Estate Planning

: Rubin on Tax

HOW NOT TO DOCUMENT SHAREHOLDER LOANS

By Charles Rubin

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The shareholders of wholly owned corporations often end up paying for corporate expenses out of their own wallets or checkbooks, or with their own credit cards. Sometimes this is just a matter of convenience for an occasional expense - othertimes, when the corporation is short of cash this may be a regular occurrence.

The shareholders typically want such expense payments to be treated as loans or advances to the corporation, and not a capital contribution. Loan treatment allows for repayment of such advances without the payment being treated as a taxable dividend or distribution from the corporation. As discussed in a recent Tax Court case, taxpayers also desire loan treatment so that they can obtain business bad debt treatment if the loan cannot be repaid.

While often done simply by an entry on the books of the corporation that treats the expense payment as a loan advance, more evidence of loan treatment is desirable if a strong defense against an IRS challenge on that characterization is desired. In the mentioned Tax Court case, the lack of evidence of loan treatment and intent resulted in the Tax Court not recognizing the shareholder payment of expenses as loans, and the Tax Court thus disallowed business bad debt treatment for the shareholder when the advances were not repaid.

What type of evidence of a loan is desired to avoid a similar result? The Tax Court provided a roadmap of what it was looking for (and what was not present):

Mr. Bynum and SEI did not have a debtor-creditor relationship. Mr. Bynum certainly paid and substantiated a wide array of business expenses, but these payments were not loans to SEI. First, there was no valid and enforceable obligation to pay a fixed or determinable amount of money. Second, there was no oral or written agreement establishing a debtor-creditor relationship. Third, Mr. Bynum did not demand or receive any payments from SEI relating to the alleged loans. Finally, the expenditures were not structured as, or intended to be, loans. To keep his business afloat, Mr. Bynum routinely paid a myriad of typical business expenses. He was concerned about the survival of the business, not repayment for the expenses. In sum, Mr. Bynum's payments were contributions to capital, and not bona fide indebtedness.

The simple expedient of a promissory note with repayment terms, and/or the occasional repayment of the advances, would have gone a long way toward allowing Mr. Bynum the loan treatment he sought.

Douglas Bynum, Jr., et ux., TC Memo 2008-14

Full post as published by Rubin on Tax on February 14, 2008 (boomark / email).