Proper documentation of shareholder loans critical in preventing unfavorable treatment as dividends
Mar 29, 2011
Many small business owners use profits accumulated inside a company very loosely as a personal checkbook or as a source of funds for non-business purposes like paying taxes, personal investments or real estate purchases.
Failure to properly document shareholder loans can lead to them being taxed currently as a dividend, as compared to the expectation that these funds have already been taxed.
A recent U.S. Tax Court case (Knutsen-Rowell, Inc. et al. v Commissioner of Internal Revenue, TC Memo 2011-65) brings this long-standing taxpayer nemesis to the forefront of thought.
To prevent the IRS from asserting undesirable tax treatment of shareholder loans as currently taxable dividends, it is critical that the loans are properly documented.
Avoid the danger of informality
Informality can be dangerous when a controlling shareholder borrows from a corporation. A withdrawal that is intended to be a loan should be documented as a loan. This includes a legally enforceable promissory note that pays an appropriate interest. Also, the transaction should be reflected as a loan on the corporation’s books and records. Repayments need to be made in accordance with the terms of the note.
To determine whether a corporate distribution to a shareholder is a non-taxable loan, as is sometimes claimed, courts have analyzed objective factors such as whether the promise to repay was evidenced by a note or other instrument, whether interest was charged, whether a fixed schedule for repayment was established, and whether collateral was given to secure payment. Other factors used to determine if a corporate distribution to a shareholder is actually a non-taxable loan include whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan and whether the parties conducted themselves as if the transaction was a loan.
For help
As you can see, properly documenting loans to shareholders is essential. As always, if you have questions about how to properly document shareholder loans, contact us via email or phone (410.685.5512). We are here to help.
