(Part 2 of 2)
LOANS to shareholders are a major issue in the audit of corporations, especially shareholder-employees who pull out lots of loans but get no or small salaries. How can you avoid shareholder loan problems? According to IRS regulations, a genuine debt occurs only when there is a legally valid and enforceable obligation. It has to be reasonable. There should be a reasonable expectation of repaying on the part of the shareholder and a reasonable expectation of enforcing the collection on the part of the corporation.
According to the Tax Court, the following factors enhance the view of a bona fide debtor-creditor relationship:
1. A promissory note or other written note of the debt is prepared and signed,
2. Interest is charged,
3. There is a fixed schedule of repayment,
4. The loan is secured by collateral,
5. If the debt becomes past due, a demand for repayment is made,
6. Your corporate books reflect the transaction as a loan,
7. Repayments are made,
8. Borrowers were solvent at the time of the loan.
Tip: Make some payments, even a small amount from time to time. This indicates the existence of a true loan. Successful defenses on IRS audits have identified the key to winning on this issue: Repaying the loans in full occasionally. Use a credit line, borrow from your credit card, and raise funds from anywhere to pay-off at the end of the year. I have personally found out through audits (that I have defended) that some repayments and a subsequent valid effort to enforce repayment have saved the day for some seemingly lost cases. I also had to contend with a typical IRS approach to loans to family members as a two-step transaction: First, as a dividend distribution from this corporation to the shareholder and, second, as a loan from the shareholder to the family member. The shareholder, not the corporation, is stuck with a non-business bad debt and has to pick up dividend income. The IRS may also argue that if it is a non-business bad debt at the corporate level, there is no corporate deduction for the loss because it is not an ordinary and necessary business loss.
In conclusion, shareholder loans become an issue on IRS audits when they are converted to constructive dividends. This problem is caused by shareholders getting loans and failing to conduct these transactions at arm’s length. The lack of formality in dealing with these loans is the usual culprits for losses at IRS audits. It is not so bad when the loans are converted to salaries because such wages are deductible by the corporation and, therefore, offset the tax effect of picking up the income on your individual income tax returns.
* * *
Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV - Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 34th anniversary in 2011. You may email tax questions to Vic at This e-mail address is being protected from spambots. You need JavaScript enabled to view it . You are welcome to visit our website for about 300 tax tips at www.victorsycpa.com.
| < Prev | Next > |
|---|
