The IRS has recently released a comprehensive guide on what to look for when the auditor sees shareholder loans on the corporation's books. While loans to the shareholder can be legitimate often times the loans are nothing more than disguised compensation or non-deductible dividends to the shareholder. The IRS has instructed its agents to probe for shareholder loans, look for imputed interest that has not been reported by the corporation, and to analyze closely to determine if the loans meet certain criteria the IRS has established to determine valid shareholder loans.
Is the amount a bona fide loan? The test to determine the validity of a loan is to determine, at the time the loan was made, whether the shareholder intended to repay the loan and whether the corporation intended to require repayment. The intent has to be demonstrated by objective or measurable facts, not just the stated intentions of the shareholder and a corporate officer. There are twelve factors the IRS uses to determine whether a bona fide loan exists or whether there is a dividend or compensation issue.
Does the shareholder own or control the corporation, either directly or indirectly such as through family?
The closer the shareholder is to owning or controlling a majority of the corporation, the less likely the IRS is to view the transaction as a loan.
Was any security given?
The failure to provide some security for the loan may indicate that no loan was intended. However, if the corporation's articles of incorporation state that liens will be placed on any shares of stock for any debt or liability incurred by the shareholder, these can mitigate the absence of any other form of security.
Can the shareholder repay the loan?
If the shareholder has sufficient salary, other income, or net worth to suggest that the shareholder is able to repay the loan, this works to buttress the argument that the distribution was in fact a loan. If the shareholder is totally dependent upon earnings from the company, this would work to suggest that the distribution was not a loan. Good credit is not conclusive to establishing that the shareholder could repay the loan.
Does the corporation have adequate earnings and profits?
While the absence of earnings and profits should indicate that the distribution could not have been a dividend, the IRS's position is that the distribution could be a taxable capital gain.
Was a note given to the corporation?
While the absence of a note is not fatal, based upon court cases, having a note between the corporation and the shareholder certainly strengthens the argument that a valid debt exists.
Is there any repayment schedule?
Attempts to repay should be made (except for short-term demand loans). Increasing shareholder loan accounts tend to trigger the suspicions of IRS auditors that there is not intention to repay the loan and that it is nothing more than disguised dividends or compensation.
Is there a set maturity date for repayment?
In the absence of a maturity date, loans paid in a reasonable period of time (not defined) will tend to corroborate that the distribution was a loan. However, term notes that are renewed for the same principal amount increased by accrued interest charges tend to suggest that there is not a bona fide loan.
Is there interest charged?
Failure to charge interest suggests that the distribution is not really a loan. Any amount over $10,000 requires the charging of interest. The interest is income to the corporation but not necessarily a deduction to the shareholder.
Has the corporation made regular attempts to obtain repayment?
Obviously loans require repayment. Failure of the corporation to attempt to obtain repayment suggests that the amounts distributed were not loans.
How large are the loans?
Large loans to a controlling shareholder, where repayment is contingent upon the future profits of the corporation, tend to suggest dividends not loans.
Is there a limit to the amount any one shareholder or groups of shareholders can borrow?
While it has not been a major issue, any limit that is placed on shareholder borrowings tends to suggest loans over dividends or compensation. Again, this is not a major issue, just one more piece to buttress your position that a loan is a loan.
Does the corporation have a history of paying dividends?
Profitable corporations that don't have a history of dividend payments tend to be viewed with a jaundiced eye when it comes to loans. However, if the corporation has a consistent dividend payment history, excess amounts over that are more favorably viewed as loans.
This is not an all-inclusive list. Agents are instructed to probe any and all information that might indicate what the party's intentions were. Any suggestion that the amount distributed was not a bona fide loan will generally result in further scrutiny by the auditor.
If the corporation is an S corporation, the auditors will generally attempt to reclassify distributions as disguised compensation. Consequently, the auditor will be attempting to determine if the compensation paid to the controlling shareholder was reasonable. If the salary was not, the auditor will most likely pursue the assessment of unpaid taxes on compensation along with underreported withholding and social security/medicare taxes. If the corporation is a C corporation, the auditor will likely look at the issue of constructive dividends. Since these are not deductible to the corporation but are taxable to the shareholder, the auditor will look to make a strong case for under-reported income, with all the accompanying penalties for under-payment of taxes.
This is not a definitive analysis of the new audit guide or the issue of shareholder loans. Instead, it is intended to alert you to the potential for audits as it relates to shareholder loans. If you or your corporation has shareholder loans on the books, you might find it most advisable to discuss this with your tax advisor. Clearly, borrowing from your corporation is a reasonable way to finance some of your activities but done incorrectly, it can give the IRS auditor one more issue to examine, possible to your detriment.
Review the IRS audit guide or contact us with any questions or comments.