Over nearly three decades, I have reviewed the income tax returns of many closely held corporations and partnerships. Quite often, on Schedule L (the Balance Sheet), I will see an entry for “loan from” shareholder or partner, as the case may be. I sometimes pause before asking the next series of questions: did the board of directors or managers approve the loan; how has the loan been documented; is there a note with repayment terms; does the loan provide for interest and, if so, at what rate; has interest been paid; does the business tax return reflect interest expense; has interest income been imputed to the owner-lender?
The proper characterization of a transfer of funds to a business entity from an owner of that entity may determine a number of potential tax consequences arising from the transfer, including, for example, the following: the imputation of interest income to the owner-lender; the ability of the lender to claim a bad debt deduction; the making of an indirect taxable gift, in the case of a family-owned business, where the “loan” is really a capital contribution. The proper characterization of the transfer is also important if the owner/lender intends to have priority in the repayment thereof over other owners.
If a transfer of funds to a closely held business is, in fact, intended to be treated as a loan, then there are a number of factors that are indicative of bona fide debt of which both the lender and the borrower should be aware:
– Evidence of indebtedness (such as a promissory note);
– Adequate security for the indebtedness;
– A repayment schedule, a fixed repayment date, or a provision for demanding repayment;
– Business records (including tax returns) reflecting the transaction as a loan;
– Actual payments in accordance with the terms of the loan;
– Adequate interest charges (at least the applicable federal rate); and
– Enforcement of the loan terms.
The big question is “was there a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?” (Cite). The transaction will come under special scrutiny where the borrowing entity is controlled by the lender and/or members of his or her family. In that case, especially, can it be shown that there was a realistic expectation of repayment? Would a third party lender have made the loan on similar terms? Was there an actual transfer of funds in conjunction with any notes, or did the issuance of notes seek to “recharacterize” the nature of the cumulative funds previously transferred to the entity by the purported lender?
A recent Tax Court decision involved a family-owned business that had encountered financial difficulties. The company needed capital and the taxpayer-family member (who also served as the company’s CFO) agreed to commit to a revolving line of credit. A note was executed, but the stated interest was not payable currently and the credit was unsecured. No interest or principal was ever paid on the note. Though the company’s situation continued to deteriorate, and there were insufficient funds to pay all creditors, the taxpayer nevertheless continued to transfer funds to the company until the latter finally failed.
The Tax Court Considers the “Loan”
The taxpayer claimed a worthless debt deduction for the funds transferred to the company. When challenged by the IRS, however, the taxpayer was unable to produce any records regarding the company’s net worth; she was unable to show that the company recognized COD income; it was unclear whether the taxpayer made a demand for payment; she never commenced legal action to secure repayment, nor did she obtain a valuation that the note was worthless – rather, she drew an independent conclusion as the company’s CFO.
The Court began by noting that whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case. Advances made by an investor to a closely held or controlled corporation, the Court stated, may properly be characterized, not as a bona fide loan, but as a capital contribution or as a gift. In order to constitute a bona fide loan, the purported activity must expect that the amount advanced will be repaid. “Economic reality provides the touchstone,” the Court said. If an outside lender would not have loaned funds to the corporation on the same term as did the insider, the inference arises that the advance is not a true loan.
Under the facts presented, there was no evidence that a third party lender would have extended credit on comparable terms. The taxpayer’s behavior as the company’s condition deteriorated was likewise inconsistent with what one would expect from a third-party lender. The court, therefore, concluded that the advances were not loans and could not generate a worthless debt deduction.
The foregoing is an example of only one situation in which the proper characterization (or, from the perspective of the IRS, the “recharacterization”) of a transfer of funds can have significant tax consequences. Others include intra-family loans (which may be treated as gifts), intercompany loans (which may be treated as distributions to the owners of the lender, then as capital contributions by them to an affiliated entity), and loans to shareholder-employees, which may be treated as distributions or compensation. The bottom line: decide early on what is intended, then act accordingly.
I, for one, hate surprises.