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Wednesday, August 22, 2012


The question often comes up whether a distribution to a shareholder is a taxable distribution (e.g., a dividend), or a nontaxable loan. A recent 5th Circuit Court of Appeals decision listed the general considerations courts will consider, and applied those considerations to the facts of the case.

Generally, the test of whether a distribution is a loan is whether there was an intent that the advanced monies be repaid. The following seven objective factors are what courts will focus on:

(1) Whether the promise to repay was evidenced by a note or other instrument. In the case, the note was not signed until six months after the distribution, so even though there was a promissory note its late preparation was an unfavorable fact for finding a loan.

(2) Whether interest was charged. In the case, interest was charged, which was a good thing, but the rate was below the market, which was not a favorable factor for a loan.

(3) Whether a fixed schedule for repayment was established. A schedule was provided, but not until 3 months after the first payment was due.

(4) Whether collateral was given to secure payment. In the case, the note was secured.

(5) Whether repayments were made. In the case, no payments had been made – obviously, not a good fact for finding a valid loan. While there were insurance mechanisms to allow for eventual payment if necessary from a plan death benefit, there were too many contingencies attached to such payment to treat it as an actual payment.

(6) Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan. The borrower was a neurosurgeon who made a good living, so there was a reasonable prospect of repayment.

(7) Whether the parties conducted themselves as if the transaction was a loan. Not here – they did not make payments in accordance with the note, and no collection was attempted.

So how do you think the court ruled? Both the Tax Court and the appellate court found that there was no bona fide loan.

Clearly, taxpayers seeking loan treatment in similar circumstances should attempt to meet as many of the above factors as possible.

Todd, II v. Comm., 110 AFTR 2d ¶ 2012-5205 (CA 5 8/16/2012)

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