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Reprinted From: The News Journal
Written By: John H. Sterling, CPA
Owners of closely held businesses often borrow from their firms. But take great care when doing that, or you may face the wrath of the Internal Revenue Service.

Even if the financial statements classify the withdrawal as a loan, the IRS has the authority to recharacterize it as a dividend or distribution. A recent U.S. Tax Court case illustrates how dangerous no-arm's length transactions can be when a controlling shareholder borrows from a corporation.

In the case, a husband and wife owned the corporation. The husband ran the company and dealt with it very informally. He took money out as he needed, had it pay personal expenses, and received a $100 check in addition to each weekly paycheck.

The withdrawals were recorded on the corporation's books as "shareholder advances," and were shown as loans on financial statements given to third parties by both the shareholders and the corporation. At the end of every year, part of the outstanding balance was repaid by crediting the husband's year end bonuses against the loan.

The IRS audited the corporation and determined the shareholder advances weren't true loans, and treated them as individuals. The Tax Court agreed. The husband argued that the casual way in which he and the corporation handled the advances shouldn't be held against him because all of his dealings with the corporation were informal.

The court disagreed with this and all of the husband's other arguments. It wanted proof that he intended to repay the advances, and that the corporation intended to require repayment. Since the husband could not convince the court that the withdrawals were loans, they were deemed to be constructive dividends.

The court said the shareholder used the corporation "as a deep pocket from which he could extract funds at will and deposit funds ... at his convenience.

The withdrawals were taxable as ordinary income because the company was a C-corporation with sufficient current and accumulated earnings and profits. If the withdrawals had exceeded earnings and profits, they would first have been applied to reduce stock basis, and then been taxed as capital gains.

If the corporation was an S-corporation, the withdrawal would have first been tax-free reductions of its accumulated adjustments account; then, the tax consequences would generally have been the same as for a C-corporation. If they had been treated as bona fide loans, they would have been tax-free.

The test for whether a withdrawal is a loan is whether, at the time it was made, the shareholder intended to repay it and the corporation intended to require repayment. However, as the above case show, it's not enough proof that each testify that the requisite intent was there.

There are many factors that the courts look at when trying to decide whether a shareholder withdrawal is a loan. Most of these factors are within the shareholder's and corporation's control. It isn't necessary that each one of the factors be present to indicate a loan, but taken together they must be able to overcome the IRS's presumption that the correct treatment is a dividend or distribution.

To avoid constructive dividend/distribution treatment, the owners of a corporation should observe certain formalities when making withdrawals. Where possible, all of the following should be done to ensure loan treatment.

First, the withdrawal should be documented as a loan and a legally enforceable promissory note should exist. Interest should at a minimum be provided for at the applicable federal rate. Collateral should be provided where appropriate.

The transaction should be shown as a loan on the corporation's books and records. It should be listed on any financial statements of either the shareholder or the corporation.

Finally, repayments should be made in accordance with the terms of the promissory note. A demand loan should be repaid within a reasonable amount of time. Small repayments and continued growth of the loan, or full repayment at the end of the year followed by renewal of the loan at the beginning of the next year, do not show a true debtor-creditor relationship.