It has become common for shareholders of closely held businesses to infuse and extract cash from their companies on a regular basis. These advances and withdrawals are often categorized as shareholder loans, but the documents supporting these loan categorizations are not often seen. Why should this concern you? Well, even if you call a transaction between yourself and your company a loan, the IRS can re-categorize that transaction as something entirely different causing you, as a shareholder, to experience a variety of negative consequences.
Let’s imagine a situation in which a company is experiencing cash flow problems. In order to meet certain financial obligations, the shareholder advances personal funds to the company or uses other personal resources, such as personal credit cards, to pay a company bill or purchase company supplies. In most cases, that shareholder is expecting to be reimbursed for covering the company’s obligations. Certainly, there are tax advantages to having the advances treated as debt rather than equity. Cash can be withdrawn from the company as a reimbursement of the advances without being taxed. Interest payments on the advances are deductible expenses to the company and are often another way of extracting cash from companies at a lower tax cost. Furthermore, if a company liquidates or declares bankruptcy, a true debt obligation, even to a shareholder, will be paid before any equity is returned. Its repayment will not be a taxable transaction. In fact, if structured properly, the loan may have priority of payment over other company debts.
Conversely, a shareholder may withdraw funds from his company to cover personal obligations or acquire personal assets. If that is the case, treating the withdrawal as a loan to the shareholder allows the shareholder to avoid reporting the receipt of the funds as taxable compensation, a taxable dividend or a distribution that reduces his basis in his stock.
However, just because a shareholder wants his advances to be treated as debt does not mean that the IRS will treat them as such. Whether the withdrawal of funds by a shareholder from his company or an advance made by a shareholder to his company creates a true debtor-creditor relationship is a factual question to be decided based on all the relevant facts and circumstances.
For a withdrawal of funds by a shareholder, or an advance made by a shareholder, to constitute a bona fide loan, there must have been, at the time the funds were transferred, an unconditional obligation on the part of the transferee to repay the money. In addition, there must have been an unconditional intention on the part of the transferor to secure repayment. However, many shareholders fail to ensure that there is clear evidence of their obligations and intentions. Unfortunately, courts cannot look into the minds of taxpayers to ascertain their intentions; therefore, they must rely on a set of objective factors to assist in determining whether the appropriate intention to create a debt is present. The relevant factors considered for purposes of identifying bona fide loans include: (1) the existence or nonexistence of a debt instrument; (2) provisions for security, interest payments and a fixed payment date; (3) treatment of the funds on the company’s books; (4) whether repayments were made; (5) the extent of the shareholder’s participation in management; and (6) the effect of the “loan” on the shareholder’s or employee’s salary.
A shareholder wishing to preserve the classification of a withdrawal or advance as a bona fide debt should treat the transaction as he would an arm’s length transaction and apply normal business standards to it. Any reasonable businessperson, when loaning sums of money, would obtain a note or other instrument recognizing the debt. Therefore, the absence of notes or other instruments of indebtedness is an indication that the advances or withdrawals were capital contributions, distributions or compensation as opposed to loans.
However, simply calling a document a “note” does not guarantee that it will be respected as such. Shareholders need to ensure that the document evidencing a loan contains the characteristics of a typical debt arrangement. For instance, there should be a stated interest rate and a provision for repayment. The interest rate charged may vary; however, shareholders should beware of charging too little or too much interest. A safe bet is to charge a rate equal to the applicable federal rate effective for the month the loan was issued.
The lack of a specified date for repayment is usually taken as evidence that an advance or withdrawal is not a debt. For this reason, demand notes are vulnerable. However, if repayment is to be on demand, the note should, at a minimum, provide for the annual payment of interest accrued. Shareholders may also want to consider including, in the demand note, periodic adjustments of the interest rate to keep it commercially reasonable. It is also important to keep in mind that the courts tend to look at a note containing a fixed maturity date far into the future as evidence that it is not a true debt.
Significant advances or withdrawals treated as loans should also be secured by assets to ensure their repayment. For example, if a shareholder advances the company a substantial sum of money to purchase or even put a down payment on a piece of equipment, it is appropriate for that shareholder to take a security interest in that piece of equipment. Filing a lien or other security agreement against that asset can, in certain cases, give a shareholder a priority interest in that asset in the case of bankruptcy or liquidation. This will limit other corporate creditors’ ability to force the sale of that equipment and claim the sale proceeds.
In determining whether a company and its shareholder intended to create a bona fide debtor-creditor relationship, courts often consider the parties’ history of payments. A company’s failure to make interest and principal payments as scheduled may be very damaging to a claim of debt status. On the other hand, regular payments of interest or principal may help to prove that a true debt was created.
Failure to list the advances or withdrawals as loans on the company’s books in a timely manner may also indicate that a true debt was not created. After-the-fact consolidation of multiple prior advances into a single note is a dangerous practice in which the advances will not be repaid in the short term. This action tends to indicate that the shareholder did not intend to treat the advance as a loan at the time it was made. In addition, a loan to a shareholder from his company with a balance that continues to increase without any repayments being made is evidence that some or all of the withdrawals are distributions or compensation and not a loan.
Finally, a shareholder’s withdrawals that are far in excess of his regular compensation may indicate that the withdrawals are not a debt. Even if a shareholder properly documents the withdrawals as loans and makes regular payments of interest and principal from the company, the transactions may still be reclassified as compensation or distributions to the shareholder. Simply put, the IRS will not allow shareholders to avoid paying themselves a reasonable compensation by taking money out of the company as loans instead of a salary.
So, shareholders take note—if you don’t want to classify a transaction between you and your company as a loan and preserve the tax benefits of such a classification, you must document, document, document. Don’t get burned by the paperless loan!