Transactions between a closely held business and its owners will generally be subject to heightened scrutiny by a taxing authority, and the labels attached to such transactions by the parties have limited significance unless they are supported by objective evidence. Thus, arrangements that purport to provide for the payment of compensation, dividends, rent, interest, etc., will be examined, and possibly re-characterized, by a taxing authority so as to comport with what would be required in an arm’s-length setting.

 Notwithstanding the many instances in which the IRS and the courts have successfully treated a transaction between a close business and its owners as something other than what was reported on their respective tax returns, we continue to see examples of taxpayers who either have been ill-advised or are just plain careless in their dealings with one another.

A recent Tax Court decision involved an S corporation with a single shareholder, who also served as the president of the corporation. This individual was responsible for all operational and financial decisions of the corporation, and performed nearly all of the work necessary to run the business. He worked full-time for the business, which had no other employees.

During the years at issue, the business experienced some financial difficulties. The shareholder transferred cash to the corporation; no promissory note was issued to reflect the transfer, and no collateral was given.

On the S corporation tax returns for these years, the corporation did not report paying the shareholder any salary or wages. It did, however, distribute money to him as cash was available. It also reported the repayment of loans from the shareholder.

The IRS determined that the shareholder should have been classified as an employee of the corporation and that the distributions should be characterized as wages. The Court agreed, stating that the evidence supported the IRS’s findings: “An employer cannot avoid Federal employment taxes by characterizing payments to its sole employee, officer, and shareholder as dividends, rather than wages, where such payments represent remuneration for services rendered.”

The Court also rejected the taxpayer’s argument that certain distributions represented repayments of loans between the corporation and the shareholder and, as such, should not be treated as wages. The Court considered a number of factors, including the name given to the transaction by the parties, the absence of a fixed maturity date, the likely source of repayment, the charging of interest for the use of the funds, the right to enforce payments, subordination of the purported loan to other creditors, the intent of the parties, and the capitalization of the corporation.  Ultimately, it found that it must determine “whether the transfer, analyzed in terms of economic reality, constitutes risk capital . . . subject to the fortunes of the [business] or a strict debtor-creditor relationship.” Applying the above factors, the Court concluded that the transfers were capital contributions and not bona fide loans. “Where the expectation of repayment depends solely on the success of the borrower’s business, rather than on the unconditional obligation to repay, the transaction has the appearance of a capital contribution.”

Finally, the Court addressed the taxpayer’s argument that the characterization of all distributions to the shareholder as wages would constitute unreasonable compensation to him and, so, some portion thereof should continue to be treated as distributions in respect of his shares in the corporation. The Court responded that there was no evidence to support a finding that the compensation was unreasonable for the services provided.

The foregoing illustrates only one of the many possible outcomes of an IRS audit involving an owner’s transactions with his or her closely held business. Each situation is different and the results will ultimately depend upon the particular facts and circumstances. Thus, in the “right” situation, a payment of compensation may be re-characterized as a nondeductible dividend, a non-pro rata distribution may be treated as a gift, a payment of rent may be re-characterized as compensation, the use of company property may be treated as a dividend, and so forth.

It is important to recognize that the proper characterization (or, from the perspective of the IRS, the “re-characterization”) of a transaction can have significant tax consequences.  The bottom line: decide early on what is intended, then act accordingly. It may require more consideration initially, but it will provide certainty and it may avoid an expensive tax result down the road.

 In the next few blog posts, we will consider other recent situations involving transactions between owners and their closely held businesses.