It is fairly commonplace for owners of closely held corporations to loan funds to their corporation without full loan documentation. Oftentimes, there is nothing establishing the debt other than an entry on the corporation books, without any mandatory repayment date. A recent Tax Court case instructs that the absence of more comprehensive loan documentation in terms can result in the disregard of loan status. If the loan status is not respected, repayments may constitute taxable distributions or compensation payments.
In the case, the sole stockholder of an S corporation transferred funds to the corporation. Such advances were characterized as loans on the tax return of the corporation. The taxpayer later treated payments to the shareholder as a repayment of the loan. The IRS challenged and was successful before the Tax Court in converting those payments from a nontaxable loan repayment to taxable compensation income to the stockholder.
The bottom line here is that the IRS was not convinced that the advances were loans instead of capital contributions. Factors that influenced the court included a lack of written agreements or promissory notes, a lack of interest, no security, and no fixed repayment schedule. Repayment was seen as dependent on the success of the business (since payments were made out of positive cash flow) and not as an unconditional obligation.
To avoid these issues, loans to closely held shareholders should bear as many of the following indicia of loan as possible:
a. A written obligation;
c. Fixed repayment schedule and maturity date:
d. Security for repayment;
e. A reasonable debt/equity ratio;
f. Minimal or no subordination to other creditors of the corporation; and
g. Actual repayments independent of profits.
Clearly, not all of these are necessary. However, the case does suggest that at least items a.-c. should be included at a minimum.
Another important fact here is that the stockholder was a key employee of the company, but received no wages or other compensation. If that had occurred, that would have been another helpful fact for the taxpayer.
Glass Blocks Unlimited, TC Memo 2013-180