Saturday, October 08, 2005

Shareholder Prevails on Loan Characterization

Shareholders of Subchapter C corporations (that is, corporations that have not elected Subchapter S status) are subject to tax on dividends distributed from the corporation (to extent of the undistributed earnings of the corporation). To avoid or defer this tax, shareholders do a lot of things to get access to the money but not pay the tax. One common mechanism is for the shareholder to borrow the money from the corporation so that it is not treated as a dividend distribution. Shareholders that do this need to cross their i's and dot their t's - have a written promissory note, a reasonable rate of interest, have security for the debt, and other evidence of arms-length debt to overcome an IRS that is interested in characterizing the loan as a dividend distribution.

Note, however, that the lack of proper documentation is not always fatal to loan treatment should the IRS contest the issue. In a recent Tax Court case, the IRS's determination that a software developer/consultant had constructive dividends from advances which his closely owned consulting corporation made to him or on his behalf, and which were used for new home purchase and various personal expenses, was rejected - the taxpayer proved that the advances were nontaxable loans. Although advances weren't memorialized in any formal loan documents, weren't subject to any fixed repayment schedule, and weren't secured, loan treatment was still supported by facts taxpayer made reasonable interest payments, repaid a relatively substantial portion of the loan principal, had reasonable prospects of repaying balance, and had expressly agreed with another shareholder to use the funds as loans. Nariman Teymourian v. Commissioner, TC Memo 2005-232, 2005 RIA TC Memo ¶2005-232 (2005).
Post a Comment