Same Old Story
This probably sounds familiar: You are reviewing an already-filed tax return for a closely held business, and you see that the balance sheet reflects a liability that is identified as “loans from shareholders.” You ask to see the loan agreement or promissory note that memorializes the loan. “There aren’t any,” you are told. You then ask for the board or management resolutions that approved the loan – you are answered with a blank stare. You then ask what the terms of the loan are: interest rate, payment terms, maturity date, collateral? Again, silence – it’s deafening. “Have you at least reported imputed interest income?” you ask. “Was I supposed to?” comes the response.
“Not again,” you think to yourself, but you inquire anyway, as hope springs eternal: “What did you intend by transferring these funds to the business entity? Were these really intended to be loans, or capital contributions?”
Here it comes – wait on it – “What would be better for me?” asks the business owner.
By now, you know this blog’s mantra: “plan in advance, leave little to chance.”
Every now and then, however, a taxpayer who has not dotted and crossed the proverbial “i’s” and “t’s” catches a break, as illustrated by a recent Tax Court decision.
Funding the Business
Taxpayer was an S corporation, and Shareholder was its sole shareholder and sole corporate officer.
Although it had a “rough start,” Taxpayer’s business quickly grew. On several occasions, Taxpayer was forced to move to larger locations to meet increased demand. In order to fund Taxpayer’s growth, Shareholder began raising money from various sources. In 2006, he established a home equity line of credit. In no time, he had drawn on the entire line and advanced the funds to Taxpayer. Shareholder then established another line of credit by refinancing a home mortgage, the entire amount of which he advanced to Taxpayer. In 2008, he established a general business line of credit and advanced all the funds to Taxpayer. Shareholder also borrowed from his family and advanced all the funds to Taxpayer throughout 2007 and 2008.
Taxpayer reported all of the advances as loans from Shareholder on its general ledgers and on its Forms 1120S, U.S. Income Tax Return for an S Corporation, but there were no promissory notes between Shareholder and Taxpayer, there was no interest charged, and there were no maturity dates imposed.
Times Got Hard
While Taxpayer was initially profitable, there was a decline in business in 2008, with the recession. Because Shareholder was unable to borrow from commercial banks, he financed Taxpayer’s operations from 2009 through 2011 by borrowing additional funds from his family and then advancing the funds to Taxpayer. Shareholder also began charging business expenses to his personal credit cards. Again, there were no promissory notes executed between Shareholder and Taxpayer, but Taxpayer reported the advances on its general ledgers and tax returns as loans from Shareholder.
Taxpayer reported operating losses during the years at issue (2010 and 2011). During the same years, Taxpayer paid significant personal expenses of Shareholder by making payments from its bank account to Shareholder’s creditors. These payments made on behalf of Shareholder were treated on Taxpayer’s general ledgers and tax returns as repayments of Shareholder loans. Taxpayer did not deduct the payments made on behalf of Shareholder as business expenses.
Shareholder worked full-time for Taxpayer, and occasionally employed other individuals to help with Taxpayer’s operations. Taxpayer filed employment tax returns, and paid employment taxes on wages paid to each employee except Shareholder – Taxpayer did not report paying wages to Shareholder during the years at issue.
Wages or Repayments of Debt?
The IRS determined that Shareholder was an employee of Taxpayer for the years at issue, and that Taxpayer’s payment of Shareholder’s personal expenses constituted wages that should have been subject to employment taxes.
Taxpayer petitioned the Tax Court to decide whether Taxpayer’s payment of personal expenses on behalf of Shareholder should be characterized as wages subject to employment taxes.
Employers are required to make periodic deposits of amounts withheld from employees’ wages and amounts corresponding to the employer’s share of FICA and FUTA tax.
“Employee” is defined for FICA and FUTA purposes to include “any officer of a corporation” and “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.” An officer of a corporation who performs more than minor services and receives remuneration for such services is a “statutory” employee for employment tax purposes.
Taxpayer did not object to the IRS’s determination that Shareholder was its employee for the years at issue: Shareholder was Taxpayer’s only officer, and he performed substantial services for Taxpayer. Accordingly, Shareholder was an employee of Taxpayer for the years at issue.
The Court’s Analysis
The central issue for the Court was whether Taxpayer’s payments made on behalf of Shareholder should have been characterized as wages subject to employment taxes.
Taxpayer argued that the advances Shareholder made to it were loans and that payments made on behalf of Shareholder represented repayments of those loans.
The IRS argued that the funds advanced to Taxpayer were contributions to capital and that payments made on behalf of Shareholder were wages.
The Court began by explaining that proper characterization of the transfers to Taxpayer as either loans or capital contributions had to be made by reference to all the evidence. Taxpayer had the burden of proving that the transfers were loans.
Courts have established a non-exclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include:
(1) the names given to the documents that would be evidence of the purported loans;
(2) the presence or absence of a fixed maturity date;
(3) the likely source of repayment;
(4) the right to enforce payments;
(5) participation in management as a result of the advances;
(6) subordination of the purported loans to the loans of the corporation’s creditors;
(7) the intent of the parties;
(8) identity of interest between creditor and stockholder;
(9) the ability of the corporation to obtain financing from outside sources;
(10) thinness of capital structure in relation to debt;
(11) use to which the funds were put;
(12) the failure of the corporation to repay; and
(13) the risk involved in making the transfers.
According to the Court, these factors serve only as aids in evaluating whether transfers of funds to a closely held corporation should be regarded as capital contributions or as bona fide loans. No single factor is controlling.
The ultimate question is whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship.
Transfers to closely held corporations by controlling shareholders, the Court stated, are subject to heightened scrutiny, however, and the labels attached to such transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless these labels are supported by other objective evidence.
What Was Intended?
In its analysis, the Court focused on: the relative financial status of Taxpayer at the time the advances were made; the financial status of Taxpayer at the time the advances were repaid; the relationship between Shareholder and Taxpayer; the method by which the advances were repaid; the consistency with which the advances were repaid; and the way the advances were accounted for on Taxpayer’s financial statements and tax returns.
The Court reviewed the evidence of Shareholder’s intention to create a debtor-creditor relationship with Taxpayer. Taxpayer reported the advances as loans on its general ledgers and its tax returns. Taxpayer’s balance sheets reported Shareholder’s advances as increases in loans from Shareholder each year. Additionally, Taxpayer consistently reported the expenses it was paying on behalf of the Shareholder as repayments of loans rather than as business expenses. While the Court recognized that transfers by Shareholder as the controlling shareholder (and the corresponding labels attached to such transfers) were subject to heightened scrutiny, it believed Shareholder provided enough objective evidence to overcome the higher standard.
The Court found that this consistent reporting indicated Shareholder and Taxpayer intended to form a debtor-creditor relationship and that Taxpayer conformed to that intention. Taxpayer’s payments on behalf of the Shareholder were consistent regardless of the value of the services Shareholder provided to Taxpayer. Many of the payments Taxpayer made were the Shareholder’s recurring monthly expenses, including his home mortgage and personal vehicle loan payments. The consistency of these payments, both in time and in amount, the Court noted, was characteristic of debt repayments. Finally, and most importantly, the fact that Taxpayer made payments when it was operating at a loss strongly suggested a debtor-creditor relationship existed. “A fundamental difference between a creditor and an equity investor is that the former expects repayment of principal and compensation for the use of money * * * whereas the latter understands that the return of its investment, and any return on that investment, depend on the success of the business.”
Consequently, the Court decided that Shareholder’s advances were intended to be loans because Shareholder was repaid even when the business was operating at a loss and the repayments were, therefore, not dependent on the success of the business.
Expectation of Repayment
The Court turned next to the question of whether Shareholder had a reasonable expectation of repayment.
When Shareholder advanced funds to Taxpayer during 2006 through 2008, the business was well-established and successful. Because Taxpayer was operating profitably and showed signs of growth, the Court believed that Shareholder was reasonable in assuming his loans would be repaid. Accordingly, the Court found that Taxpayer and Shareholder intended the advances to create debt rather than equity, that there was a reasonable expectation at the time the initial advances were made that such advances would be repaid, and that such intention comported with the economic reality of creating a debtor-creditor relationship.
Although the Court recognized that Shareholder’s advances had some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule – it did not believe those factors outweighed the evidence of intent.
However, the Court could not find that all of the advances were loans. While it believed that Shareholder had a reasonable expectation of repayment for advances made between 2006 and 2008, the Court did not find that a similarly reasonable expectation of repayment existed for later advances. When the recession began in 2008 and Taxpayer’s business dropped off sharply, Shareholder should have known that future advances would not result in consistent repayments. When neither Taxpayer nor Shareholder was able to raise funds from unrelated third parties, Shareholder must have recognized, the Court stated, that the only hope for recovery of the amounts previously advanced to Taxpayer was an infusion of capital subject to substantial risk. After 2008, the only source of capital was from Shareholder’s family and his personal credit cards. No reasonable creditor would have loaned to Taxpayer.
Accordingly, the Court found that advances made through 2008 were bona fide loans but that advances made after 2008 were more in the nature of capital contributions.
Don’t Get Comfortable
Taxpayer and Shareholder fared pretty well in the decision described above, all things considered. No promissory note, no authorization to borrow, no maturity date, no interest, no payments terms, no collateral. In other words, nothing that any reasonable third party lender would have required in making a loan.
Yet the Court was satisfied that a loan was intended based, in part, upon Taxpayer’s financial and tax reporting. More importantly, the facts and circumstances supported a finding that loans were intended for the pre-recession period.
The importance of the circumstances in which funds are transferred to a business cannot be understated. However, the closely held business needs to consider them from the perspective of a third party lender, it needs to document the transfers accordingly, and it needs to act consistently with what was intended.