While the Internal Revenue Code does have provisions that may impact the tax consequences of related party loans, conceptually there is nothing wrong with a related party loan. Loans can have favorable tax aspects, including deductibility of interest payments, principal repayments by entities being treated as such instead of taxable distributions, and bad debt deductions if the obligations cannot be repaid. Since the IRS will often seek to recast related party loans as gifts, capital contributions, or something other than a loan, taxpayers must observe all proper formalities and meet the criteria for both a “loan,” and when a bad debt deduction is sought that the loan became “worthless.”
On the “loan” side, the lender generally must show at the time of the funds advance, there was a real expectation of repayment and an intent to enforce collection. On the “worthless” side, the lender must be able to show that the debt was truly worthless in the year a deduction for worthlessness is sought.
A recent appellate decision shows the IRS will use bad facts to void loan treatment when a shareholder loans funds to a related corporation. The shareholder sought to write off $800,000 that she loaned to the corporation and that was not repaid.
Here is a list of the bad facts in the case. They are an education on what to AVOID in these situations:
- Generally speaking, the loan was not made on terms that an outsider would have undertaken.
- The loan was unsecured.
- The loan was funded over a period of time as a line of credit. During that period of time, the finances of the borrowing corporation declined – nonetheless, the lender continued to fund the loan.
- No payments of interest or principal ever were made.
- The borrowing corporation did not enter bankruptcy, and continued to operate two years after the year a worthless debt deduction was sought.
- The borrowing corporation did not recognize any cancellation of indebtedness income.
- The lender’s only effort to enforce the debt was to make a demand for repayment of $5,000 in the year of the write off. No legal action was ever commenced.
- There were no opinions of accountants or financial consultants that the note was worthless.
- There was no evidence of borrower creditworthiness at the time of the loan was advanced (a loan to an insolvent entity will often not be characterized as a loan).
- The loan was a line of credit loan, but it had no covenants that advances could be suspended if certain income or other benchmarks were not attained or maintained.
- No event of default occurred in the year that worthlessness was claimed.
SHAW v. COMM., 116 AFTR 2d 2015-XXXX, (CA9), 11/18/2015