A closely held business may come to our firm for any number of reasons. The owners may be selling the business, for example, or they may be thinking about spinning off a division. In some cases, the owners are considering the admission of a new investor, or the issuance of equity to a key employee; in others, they are contemplating whether to reorganize the business structure. Succession planning or estate planning are often motivating factors for which the owners seek our assistance. Then, of course, the business may have been notified by some taxing authority that its returns have been selected for audit.
Whatever the reason, one of the first documents we review is the most-recently filed federal income return for the business, and among the items within that return for which we search, in particular, are related party transactions, including loans to the owners.
Loan to Shareholder/Partner
How often do you encounter a situation, especially with a new client, in which the tax return balance sheet of a closely held business reports a loan to a shareholder or to a partner as an asset of the business?[i] If you’re like most tax advisers, you immediately check to see whether:
- the amount of the loan reported on the return changed during the year,[ii]
- the business reported any interest income,[iii]
- any distributions were made to the owners,[iv] or
- compensation was paid to those owners who were active in the business.[v]
Occasionally, the taxpayer will choose not to report a loan to an owner on the line designated for that purpose; instead, they include it in their response to that line of the balance sheet described as “Other assets,” which serves as a catchall.[vi]
In any case, once armed with this basic information, there are some obvious questions for the owners of the business, including, for example, “What are the terms of the loan,”[vii] “Is the loan evidenced by a promissory note?” and “Do you have board minutes describing the purpose for the loan, and approving its terms?”
Sometimes, the adviser will be pleasantly surprised to be handed a loan agreement. Upon further inquiry, however, they learn that the terms of such agreement have not been enforced, or that the interest rate has been reduced without any change in the payment terms for the loan, and without any concession (i.e., consideration) from the borrower.[x]
It is unfortunate that, in most cases, the owners of a business do not appreciate the importance of transacting with their business on terms and in a manner that resemble, as closely as is reasonably possible, their interactions with unrelated persons.[xi]
Loan to “Related Entity”
If you’ve been around closely held business entities long enough, you know that loans to shareholders or partners are not always made directly by the entity to its owners; for example, they make take the form of a loan to a “related” or “somewhat related” business entity.
“But wait,” you may say, “there is no line on the business’s tax return balance sheet for such an entry.” Not expressly,[xii] but such intercompany loans are usually found in the line for “Other assets.” This line on the return directs the taxpayer to attach a statement in which the taxpayer must, presumably, identify the asset. However, because the return instructions do not provide any guidance on this point, many taxpayers will provide the barest description of the loan; for example, “loan to affiliate” without identifying the borrower or the nature of the relationship.[xiii]
Why would a taxpayer be reluctant to provide this information?
Does It Matter?
Ostensible loans to owners in the context of any closely held business can easily affect – in fact, may be intended to affect – the economic arrangement among the owners. In doing so, however, it may generate some unintended tax consequences. For example, if a so-called “loan” is not respected as such, what was treated as a non-taxable receipt of loan proceeds by the owner-borrower – and as a nondeductible payment by the entity-lender – may, instead, be treated as a taxable dividend or compensation. In the context of an S corporation, it is possible that the loan may be treated as a second class of equity if it is determined that the arrangement was undertaken with a principal purpose of circumventing the one class of stock requirement.[xiv]
The potential for skewing the economic arrangement among the owners is even greater where the “creditor” business is owned by members of a single family. The IRS and the courts have long recognized this truth, which explains why transactions between the family and their business – as is the case for strictly intra-family transactions, generally – are subject to rigid scrutiny, and are particularly susceptible to a finding that a transfer was intended as something other than a loan.[xv]
A recent decision by the Seventh Circuit considered a history of purported loans between a family-owned holding company (“Taxpayer”), taxable as a C corporation, and a number of business entities owned by a member of the family. The issue for consideration was whether Taxpayer was entitled to bad debt deductions in respect of such loans.[xvi]
The Family Company
Taxpayer was a family-controlled company founded by Dad. Over time, it added a number of subsidiaries. Taxpayer and its subsidiaries employed Son and his siblings in various capacities. The subsidiaries operated by Son did very well. Eventually, Son became a shareholder of Taxpayer.
Son started several businesses outside of Taxpayer (the “Son-Cos”), some of which complemented Taxpayer’s business, while others competed with Taxpayer and its subsidiaries.
Notwithstanding his independent ventures, Son continued to serve as president of two of Taxpayer’s subsidiaries for a number of years. Even after he stepped down as president, his sales and customer relations role with the subsidiaries remained unchanged; in fact, Son held various licenses that were useful to the subsidiaries for obtaining certain projects.[xvii]
Need A Loan? No Credit? Bad Credit? No Problem
Over a ten-year period, including the tax years at issue, Taxpayer advanced significant sums of money to Son-Cos, including, for example, guaranties of Son-Cos’ debts, lines of credit, and payments to Son-Cos’ creditors.
Taxpayer advanced funds to Son-Cos with the goal that Son would eventually be able to manage these companies independently, and in the belief that their various projects would throw off lucrative work for Taxpayer. In other instances, Taxpayer advanced funds because it sought to preserve its own relationships with certain investors in Son-Cos.
That said, Taxpayer continued to make advances to Son-Cos even after it became apparent that the companies were financially unstable – indeed, it made loans when the companies had more debt than equity on their financial statements, when they were unable to make payments on their bank loans, and when they could not pay their bills.
What’s more, Taxpayer advanced funds even though the advances created problems for Taxpayer in obtaining surety bonds, which were integral to its own business.[xviii] In addition, Taxpayer sometimes borrowed funds to make advances to Son-Cos.
At one point, Banks, which had provided loans both to Taxpayer and Son-Cos, sought to reduce their overall exposure to Son-Cos by shifting as much of the Son-Cos debt as possible to Taxpayer. Taxpayer agreed to assume a portion of Son-Cos’ indebtedness, to guarantee the Son-Cos debt, and to subordinate to Banks any and all debts owed to it by Son-Cos.
Indeed, Taxpayer continued to advance funds even after beginning to claim bad debt deductions with respect to its earlier advances to Son-Cos.
Documentation and Collection Efforts
Taxpayer recorded its many advances to Son-Cos as notes receivable in its books and records.
According to Taxpayer’s records, it ultimately advanced over $111 million to Son-Cos,[xix] but received payments of only $28.6 million. Taxpayer also recorded that it had accrued interest income in excess of $20.8 million, but received interest payments of only $10.3 million.
At some point, Taxpayer stopped accruing interest, and paying tax on it, altogether.
Taxpayer had in its possession numerous promissory notes which purported to reflect its advances to Son-Cos. However, not all the promissory notes were signed by Son. Individuals would sometimes sign notes “imitating” Son’s signature. Some notes were signed by other individuals, and still other notes had Son’s stamped signature. Some promissory notes were unsigned.
Most of the promissory notes had fixed schedules for repayment, and renewed promissory notes were renewed without Taxpayer’s receiving payments of principal or interest. Often, promissory notes were renewed when maturity dates arose and were consolidated routinely into new, larger amounts. Taxpayer did not increase interest rates on notes that were renewed.
Although Taxpayer’s directors regularly met with Son at its offices, Taxpayer never formally requested in writing that the outstanding advances be repaid.
Taxpayer did not pursue other avenues of collection. It failed to collect through liquidating Son’s shares of Taxpayer stock, and it failed to demand repayment when Son sold one of his companies. In fact, because Taxpayer had subordinated any rights to repayments to Banks, it was unable to enforce repayment.
For the tax years at issue, Taxpayer claimed deductions on its federal corporate income tax returns[xx] for partially worthless bad debts that it asserted were owed to it by Son-Cos. Taxpayer ultimately wrote off millions of dollars’ worth of debt.
After an audit of Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, rejecting almost all of these write-offs.
Taxpayer petitioned the Tax Court to review the IRS’s determination, but the Tax Court upheld the deficiency. It determined that Taxpayer could not deduct the payments to Son-Cos as “bad debts” because Son-Cos and Taxpayer lacked a bona fide debtor-creditor relationship.[xxi]
The Tax Court on Bad Debt Deductions
As a general rule, the Code allows a deduction for “any debt which becomes worthless within the taxable year.”[xxii] That being said, the Code also distinguishes business bad debts from nonbusiness bad debts.[xxiii]
Business bad debts may be deducted against ordinary income, whether wholly or partially worthless during the year (to the extent of the amount that becomes worthless).[xxiv]
A nonbusiness bad debt may be deducted, but only when it becomes completely worthless in the year for which it is claimed, and then only as a short-term capital loss.[xxv]
In the case of a guarantor, the Code limits the deduction for bad debt losses to the amounts actually paid by the guarantor.
Taxpayer contended that it was entitled to business bad debt deductions for the tax years at issue for the advances made to, or for the benefit of, Son-Cos that became partially worthless during the years at issue.
The IRS contended that Taxpayer failed to establish that the claimed advances were bona fide debt. It further contended that Taxpayer’s motivation for advancing the funds was to provide capital injections or gifts to assist in forming new companies associated with Son, to provide disguised dividends for the use of Son’s licenses, or to provide compensation for work contracts that Son-Cos sent to Taxpayer, for services Son provided to Taxpayer, or for allegedly exchanging Son’s Taxpayer voting shares into nonvoting shares.
The Tax Court explained that there is no bad debt deduction without a bona fide debt.[xxvi] The IRS’s regulations define a bona fide debt, the Tax Court continued, as one “which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”
Stated differently, the parties to the transaction must have had an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced. An intent to establish a debtor-creditor relationship exists if the debtor intends to repay the loan and the creditor intends to enforce repayment.[xxvii]
According to the Tax Court, whether a purported debt is “in substance and fact a debt for tax purposes” is determined from the facts and circumstances of each case, with the taxpayer bearing the burden of proof.
Among the factors ordinarily considered by the courts in determining the parties’ intent, and whether a bona fide loan occurred, are the following, no single one of which is dispositive:
(1) the name given to the certificates evidencing the indebtedness,
(2) the presence or absence of a fixed maturity date,
(3) the source of payments,
(4) the right to enforce repayment,
(5) participation in management as a result of the advances,
(6) the status of the advances in relation to debts owed to regular corporate creditors,
(7) thin or adequate capitalization,
(8) the risk involved in making the advances,
(9) the identity of interest between creditor and shareholder,
(10) the use to which the advances were put,
(11) the ability to obtain loans from outside lending institutions,
(12) failure to repay advances on the due date,
(13) the intent of the parties, and
(14) the payment and accrual of interest.
After considering the circumstances of Taxpayer’s advances to or for the benefit of Son-Cos, and in the light of the factors set forth above, the Tax Court concluded that the advances did not represent bona fide debt. Taxpayer did not intend to create a bona fide debtor-creditor relationship, and the economic circumstances that existed during the time Taxpayer made its advances established that it did not reasonably expect repayment. Thus, Taxpayer was not entitled to bad debt deductions for the advances it made to Son-Cos during the tax years at issue.
Taxpayer then appealed the Tax Court’s ruling.
The Court of Appeals
Specifically, Taxpayer disputed the Tax Court’s determination that its cash payments to Son-Cos did not constitute loans that were deductible as “bad debts” when they went unpaid.
After reviewing the applicable Code and regulatory provisions, the Court framed the issue by stating that Taxpayer’s ability to claim the deduction turned on whether it had a debtor-creditor relationship with Son-Cos such that Son-Cos had an enforceable obligation to pay Taxpayer a fixed sum. To determine whether such a relationship existed, the Court looked to “a number of factors” as “indications of intent,” and reminded Taxpayer that it had the burden to establish the presence of such indicators. The Court acknowledged that courts generally view intrafamily transfers with “particular skepticism.”
Still, Taxpayer argued that the Tax Court’s “reliance on indicia of a debtor-creditor relationship prevented it from seeing the forest for the trees and that the only relevant factor is the intent of the parties.”[xxviii]
Taxpayer contended that it represented to third parties that the advances to Son-Cos were debts, and it possessed signed promissory notes, both of which indicated that it believed the advances to be debt for which it expected to be repaid.
The Court observed, however, that the way Taxpayer described the advances did not match the way that Taxpayer and Son-Cos treated those payments.[xxix] For example, the Court noted that, though many of the promissory notes had fixed maturity dates, Taxpayer routinely deferred payment or renewed the notes without any receipt of payment or other consideration.
Further, the Court pointed to evidence that Taxpayer did not expect to be repaid unless various other events occurred, such as Son-Cos securing additional investments and projects. This sort of relationship, the Court remarked, is that of an investor, not of a creditor: “[T]he creditor expects repayment regardless of the debtor corporation’s success or failure, while the investor expects to make a profit … if, as he no doubt devoutly wishes, the company is successful.”
Thus, although Taxpayer may have described the payments as debt, it did not treat them as part of an ordinary debtor-creditor relationship and, therefore, did not establish that the parties intended such a relationship.
Taxpayer had the burden of demonstrating that its payments to Son-Cos were bona fide debts that arose from a debtor-creditor relationship in which it expected Son-Cos to pay Taxpayer back in full. Because Taxpayer failed to carry its burden, the Court concluded that Taxpayer’s payments to Son-Cos were not “bad debts” qualifying for the deduction.
The key to determining the character of a payment between related parties as a loan or as something else ultimately turns on the economic reality of the payment.
If an outside lender would not have extended credit on the same terms and under similar circumstances as did the related entity, an inference may arise that the advance is not a bona fide loan.
On the other hand, if the transfer and surrounding circumstances give rise to a reasonable expectation, and an enforceable obligation, of repayment, then the relationship between the parties will resemble that of a creditor and debtor.
In that case, the form of the transaction should be consistent with, and support, its substance: a genuine loan transaction. Thus, there should be a written promise of repayment, a repayment schedule, interest, and security for the loan.
The factors identified by the Courts, above, provide helpful guidance for structuring and documenting a loan between related persons, including a business entity and any of its owners. If these factors are considered, the parties to the loan transaction will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction.
Of course, the parties will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.
[i] You’ll note that Sch. L to IRS Form 1065 refers to “[l]oans to partners (or to persons related to partners)” while Sch. L to Form 1120 does not include a reference to “persons related to shareholders.” The “related persons” are described in IRC 267(b) and 707(b).
[ii] The balance sheet asks for the amounts owing at the beginning and at the end of the year. A reduction may reflect a repayment, an increase may reflect an additional loan.
If the returns provided go back far enough, we’ll know when the loan originated, how long it has been outstanding, whether there have been any payments of principal, etc.
[iii] Actually received, or imputed under IRC Sec. 7872.
[iv] It irks me (and it will certainly irk the IRS) when I see C corporations making “loans” to shareholders that are proportionate to their stock holdings, while not making any dividend distributions.
[v] Especially in the case of an S corporation. The IRS and many courts have stated very clearly that an employee-shareholder cannot avoid employment taxes by choosing the receive “distributions” in respect of their stock rather than receiving wages in exchange for their services.
[vi] Sch. L, Line 14 of Form 1120; Sch. L, Line 13 of Form 1065; Sch. L, Line 14 of Form 1120S.
How do you think an IRS auditor is going to view this? I’m reminded of those individuals who file New York State income tax returns as non-residents and who intentionally fail to answer the question on the first page of the return regarding whether they maintain living quarters in New York.
[vii] Interest rate, collateral, payment schedule, acceleration events, events of default, remedies, etc.
[viii] In this case, the debt created is presumed to be a demand loan.
[ix] The laughter from the client following the third question is a different matter.
[x] I’ve grown tired of having this discussion in this age of low rates.
[xi] I’m not just talking tax, here. The limited liability protection afforded by the corporate and limited liability company forms of business entities are premised upon their “separateness” from their owners. There are juridical persons. Once the owners start to ignore that fact, the slippery slope will eventually allow third parties to ignore the business entity, and to pursue their business-related claims against the owners directly.
[xii] Which I’ve never understood. See, for example, IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation, on which 25%-foreign-owned domestic corporations disclose certain transactions with the foreign shareholder or with certain foreign related persons.
[xiii] At that point, I ask for the returns of any related entities – there should be a corresponding debt reported.
That being said, the IRS has, over the years, added schedules to the basic business tax return forms that require the identification of certain related persons.
Thus, for example, Form 1120, U.S. Corporation Income Tax Return, Sch. K, Line 4 asks whether any corporation or partnership owns directly 20 percent or more, or owns directly or indirectly (applying the constructive ownership rules of IRC Sec. 267(c)), 50 percent or more, of the total voting power of the corporation’s stock. Line 5 of Sch. K asks whether the corporation owned such interests in other entities. If either of these questions is answered in the affirmative, the taxpayer corporation must file Sch. G, Information on Certain Persons Owning the Corporation’s Voting Stock, to identify these related persons who may be in a position to influence how it transacts business. (But see also IRS Form 851, Affiliations Schedule.)
Form 1065, U.S. Return of Partnership Income, Sch. B, Lines 2 and 3 ask similar questions with respect to a partnership. If answered in the affirmative, the partnership must also file Sch. B-1, Information on Partners Owning 50% or More of the Partnership, to provide information regarding these related persons.
Form 1120S, U.S. Income Tax Return for an S Corporation, Sch. B, Line 4 asks a similar question as to corporations or partnerships in which the S corporation is an owner. (Of course, these entities are not eligible to be shareholders of an S corporation.)
[xiv] Reg. Sec. 1.1361-1(l)(2)(i). Preferred stock comes to mind – it is often difficult to distinguish this class of equity from a debt instrument. But see the safe harbor for “straight debt” under the S corporation rules.
[xv] For example, a gift or a distribution.
Of course, any “presumption” against loan treatment may be rebutted by an affirmative showing that there existed, at the time of the “loan,” a real expectation of repayment and an intent to enforce the collection of indebtedness.
However, that does not eliminate entirely the potential for a gift.
According to the IRS, transfers reached by the gift tax “are not confined to those which, being without a valuable consideration, accord with the common law concept of gifts; they also include other transfers of property in exchange for consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor” – for example, a below-market loan. IRC Sec. 7872. However, if such a transfer is made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), it will be considered as made for an adequate and full consideration in money or money’s worth. Reg. Sec. 25.2512-8.
[xvi] VHC Inc. v. Commissioner, No. 18-3717 (7th Cir. Aug. 6, 2020).
[xvii] Taxpayer’s board of directors determined that Son was a “key person” and that it would be in Taxpayer’s best interest to purchase keyman life insurance on his life.
[xviii] The millions of dollars of receivables Taxpayer had on its balance sheets attributable to the advances made to Son-Cos affected its ability to obtain surety bonds, which damaged Taxpayer’s ability to bid on projects that required bonding.
[xix] Did I mention that I’m up for adoption?
[xx] On IRS Form 1120.
[xxi] The Tax Court also rejected Taxpayer’s alternative arguments, including, for example, its contention that its payments to Son-Cos were ordinary and necessary business expenses.
[xxii] IRC Sec. 166. It is important to note that the creditor must be able to establish that the debt was not worthless for the year immediately preceding the year in which the deduction is claimed (i.e., the year in which the debt became worthless).
[xxiii] IRC Sec. 166(d); Reg. Sec. 1.166-5(b).
[xxiv] Reg. Sec. 1.166-3.
[xxv] IRC Sec. 166(d).
[xxvi] Reg. Sec. 1.166-1(c).
[xxvii] Reg. Sec. 1.166-1(c). A gift or a contribution to capital is not considered to create a debt for purposes of this rule.
[xxviii] As opposed to the more objective manifestations of such intent evidenced by the enumerated factors? Odd.
[xxix] Classic form vs substance.