Relationships are Hard

The well-being of a closely held business is based, in no small part, upon a number of relationships, including, for example, its dealings with customers, suppliers, service providers, employees, competitors, and government (including taxing authorities). The cultivation, management, and preservation of these relationships presents the business with many challenges. However, if I had to identify the two most-difficult-to-manage of such relationships, at least based upon the adverse tax consequences that are visited upon the business and its owners as a result of such relationships, I would point to the business’s dealings with its owners and with related companies.

This should come as no surprise. When unrelated parties are transacting with one another – as the business will do with, say, a vendor – each is seeking to maximize its potential for economic gain and to minimize its exposure to economic loss. Like any system of checks and balances, there are forces at work that encourage a reasonable resolution of the transaction; the so-called “win-win” result in which neither side wins or loses every point.

Unfortunately, these “natural” forces do not apply in the case of a closely held business because its owners generally do not view the business as something separate from themselves.

In just the last two weeks, I have encountered questions regarding a sale between commonly-owned companies, a rental between related companies, the sharing of employees between a parent and a subsidiary, a disproportionate dividend distribution by a corporation to similarly-situated shareholders, and a corporation’s guarantee of a shareholder’s personal obligation. The characteristic shared by these transactions – aside from the parties’ being “related” to one another – was the absence of any meaningful negotiation between the parties.[1]

Which brings me to one of the most frequently recurring issues raised by the IRS in its examination of closely held businesses: the true nature of an investor’s transfer of funds to the business. A recent Tax Court opinion provides a good overview of the factors to which a taxpayer-investor must be attuned.

“If You’ve Got the Money, . . . ”[2]

Taxpayer decided to transfer money to his long-time friend, Partner, provided Partner gave him an “interest” in Business. Shortly after Taxpayer transferred the funds, he and Partner together incorporated Business. Taxpayer never prepared formal loan documents for the payment, but instead recorded it in his personal books and gave a copy of that record to Partner. The two of them owned the corporation as equal shareholders, with Partner overseeing the management of Business.

As Business grew and required more capital, Taxpayer provided the money. Taxpayer kept a personal record of the amounts transferred to Business, and at the end of each year he turned it over to the corporation for inclusion in the corporate records, though Taxpayer never saw those records.

This pattern continued for several years, during which Business never ran at a profit. Eventually, Taxpayer found it necessary to seek outside financing for Business. In addition, a third owner – who became a 10% shareholder through dilution of Partner’s interest – was admitted to Business to help bear the financial burden.

Taxpayer himself continued to advance funds, though, and – amid growing concern about Business’s future – he asked for and received an additional 10% share in the corporation. After revenues continued to fall short of expectations, and after having invested over $11 million over the course of 15 years, Taxpayer finally gave up.

In 2010, Taxpayer’s attorneys prepared three promissory notes from Business. Each note was dated January 1, 2010, and was signed by Partner on behalf of Business.

In November 2010, Taxpayer sold one of his promissory notes to Partner for $1. Then, in December 2010, Business retired both Partner’s and Taxpayer’s “debt”. In exchange, Taxpayer received an additional 12.5% interest in Business (bringing his total to 82.5%).

With all this “paperwork” in place, Taxpayer’s attorneys advised him that he was entitled to claim capital losses in 2010 and 2011.

The IRS audited Taxpayer’s returns for those years and asserted tax deficiencies against Taxpayer. Taxpayer petitioned the Tax Court, where the only issue was whether Taxpayer’s advances to Business were loans or capital contributions.

Debt or Equity

Taxpayer argued that his advances to Business were bona fide debts, and the IRS argued that the advances looked more like equity.

A bona fide debt, the Court began, is one that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt, it continued, is determined by the facts and circumstances of each case.

The Court identified several factors to consider in its debt-equity analysis; it cautioned that no single factor was determinative.

Names

Formal loan documentation, such as a promissory note, tends to show that an advance is a bona fide debt.

Taxpayer did not get formal loan documentation when he made each advance. Instead, his first advance got him a 50% interest in Business, and his later advances got him a 10% increase in his ownership.

Taxpayer pointed to the January 2010 promissory notes as evidence of indebtedness, but the Court found those promissory notes were of little help in determining Taxpayer’s intent when he made the advances.

The Court also stated that the “long-after-the-fact” papering was inconsistent with how Business treated unrelated lenders.

Maturity Date

“The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation.”

Taxpayer’s alleged loans to Business had no fixed maturity date, and he explained that he expected to be paid only when Business was sold or became profitable.

Source of the Payments

The Court stated that if the source of repayments depended on earnings, an advance was more likely to be equity.

According to the Court, that’s exactly what happened here: Taxpayer admitted that he didn’t expect to receive payment until the business was profitable and he’d “be paid [his] share of the profits.”

Right to Enforce

An enforceable and definite obligation to repay an advance indicates the existence of a bona fide debt.

Taxpayer argued that Business had an enforceable and definite obligation to repay his advances both before and after the execution of the 2010 promissory notes. He argued that, before the notes, Business’s financial statements recorded his advances as loans, but the Court noted that Taxpayer pointed to no authority that this would give him a right to enforce their repayment.

In any case, Taxpayer failed to take customary steps to ensure repayment – he never asked for repayment. Moreover, the Court found that he never intended to enforce the notes.

Participation in Management

The Court stated that when a taxpayer receives a right to participate in management, or an increase in his ownership stake, in exchange for an advance, it suggests that the advance was an equity investment and not a bona fide debt.

Because Taxpayer’s initial transfer to Business came with a 50% share in the company, that advance indicated an equity investment. After that, however, Taxpayer’s participation in management was unclear. He testified that his only role was to lend money, but later said that he reviewed tax documents and cash flow statements. It does not, however, seem he was involved in the day-to-day operations of Business, and any involvement he did have was minimal.

Taxpayer did not receive additional stock for later contributions until after he had already advanced millions of dollars, and this was only a 10% increase in a failing company. He testified that he wanted the additional 10% so that he would have more control over Business’s direction, given its condition and the substantial funds he had already advanced; and he emphasized that he needed it if he was going to give Business any more money.

The Court observed that an increased interest or participation needed to prevent a company’s collapse did not, by itself, mean an advance was an equity investment. But Taxpayer also received an extra 12.5% interest in Business in 2010 when it retired his debt.

Status Equal or Inferior to Other Creditors

Taking a subordinate position to other creditors indicates an equity investment.

Taxpayer admitted that his purported loans were subordinate to those of Business’s secured creditors. He argued, however, that they were not subordinate to those of Business’s unsecured creditors, though the Court noted that there was nothing in the record to support this position. And Taxpayer in fact testified that his “debt” was subordinate to several other of Business’s financial arrangements.

The Parties’ Intent

“[T]he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties.” The Court treated this factor as “the place to look for contemporaneous evidence of subjective intent.”

That evidence showed that Taxpayer never received or demanded payments of either interest or principal from Business, and that he expected to be paid back only out of profits.

That evidence also showed no contemporaneous documentation from Business that stated the advances were loans, a lack which was telling because Business did borrow money from more conventional lenders, and it papered those transactions as conventional loans.

Taxpayer admitted that during the time he was making advances to Business, he did not know for sure that they were being recorded as loans in its books.

While Business’s financial statements showed that they included Taxpayer’s advances in their total debt, the Court gave this little weight because no one from Business, other than Taxpayer, testified on its behalf.

“Thin” or Adequate Capitalization

The Court stated that thin or inadequate capitalization was strong evidence of a capital contribution where: “(1) The debt to equity ratio was initially high, (2) the parties realized that it would likely go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.”

However, neither Taxpayer nor the IRS argued that evidence in the record directly supported or negated this factor.

Identity of Interest

Advances in proportion to the stockholder’s capital interest indicate a finding that the advance was an equity investment.

Business’s financial records indicated that its liabilities exceeded its assets. And when Business lacked money to cover its operating expenses, Taxpayer just handed over the funds. These circumstances, the Court stated, create an identity of interest between the purported creditor and the controlling shareholder.

Payment of Interest Out of “Dividend” Money

The presence of a fixed rate of interest, and the actual payment of interest, indicate a bona fide debt.

There was no evidence, aside from Taxpayer’s testimony, that his advances were supposed to accrue interest. In addition, Business never paid any interest, and Taxpayer never asked for it. “The failure to insist on interest payments indicates that the payors are not expecting substantial interest income, but are more interested in the future earnings of the corporation or the increased market value of their interest.”

The Ability to Obtain Loans From Outside Lenders

If a corporation is able to borrow funds from an outside source at the time of the advance, the transaction looks more like a bona fide debt.

The Court claimed that the IRS had mistakenly distorted this factor to say that, although Business was able to obtain financing from other lenders, those transactions were at arm’s length and Taxpayer’s were not, and so should count against him.

The Court’s Decision

Based upon the foregoing factors, the Court concluded that the absence of the normal incidents of a loan, especially a maturity date and a stated interest rate, were the most telling. Without those aspects of a loan, the Court stated, the advances looked much more like capital contributions. Moreover, the “papering” that Taxpayer’s advisers prepared in 2010 to make the advances look more like loans just made it more likely than not that, at the time of the advances, Taxpayer and Partner intended those advances to be capital contributions.

Which brings us back to where we started: unrelated parties would have behaved differently in structuring the terms of a transaction than Taxpayer and Business did with respect to the transfers made to Business. (Indeed, the unrelated party would not have continued funding Business as Taxpayer did.) The unrelated party would have “papered” the transfers as loans on a contemporaneous basis, and would have required a maturity date, scheduled interest payments, covenants regarding expenditures and dividends, periodic financial reports, etc.

Unfortunately, as stated earlier, too many owners treat their business as their alter ego. Consequently, they sometimes treat their business, or cause their business to treat them, in a way that an unrelated party wouldn’t. While this may generate some inquiries by taxing authorities, it may also strain relationships with, and even antagonize, minority owners (including disgruntled family members), which can lead to a world of hurt, both financially and emotionally.[3] Ultimately, the owner must realize that it is in their own, long-term self-interest to act at arm’s-length with their business.


(*) A tax twist on the “golden rule.” Apologies to Matthew, 7:12 (the sermon on the mount).

[2] Of course, the relationship between the parties accounted for the absence of arm’s-length dealing. This sounds like the criticism leveled by the IRS at many gift and estate tax planning transactions (including certain sales to trusts and FLP transactions, for example) – no coincidence there.

[3] Apologies to Lefty Frizzell – I prefer Willie Nelson’s rendition.

[4] There’s a reason minority owners may claim “self-dealing” by a controlling owner.