The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.
Among the most prevalent and cherished characteristics of S corporations is the perception by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.
On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.
In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.
All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged. (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)
The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.
With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.
The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:
- The names given to the documents that would be evidence of the purported loans;
- The presence or absence of a fixed maturity date;
- The likely source of repayment;
- The right to enforce payments;
- Participation in management as a result of the advances;
- Subordination of the purported loans to the loans of the corporation's creditors;
- The intent of the parties;
- The capitalization of the corporation;
- The ability of the corporation to obtain financing from outside sources;
- Thinness of capital structure in relation to debt;
- Use to which the funds were put;
- The failure of the corporation to repay; and
- The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)
These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.