Own your own business? Be careful of those "shareholder loans"!

If you are a small business owner, the tax court case described below demonstrates why corporate board minutes, board resolutions, notes with repayment terms and a general plan for compensating yourself are vitally important.  It is especially true in a C Corporation but there are similar ramifications to all you S Corp shareholders out there.

 

A husband and wife both conducted business through their separate wholly-owned corporations and regularly withdrew funds from both corporations to pay living expenses for themselves and their children.  The payments were classified as "loans to shareholder" and there was no specific rhyme or reason to the frequency or amount disbursed. The Tax Court acknowledged that formalities involving shareholders and closely held corporations are not always followed, but still rejected taxpayer's claim that the distributions were repayments of loans or new loans to the shareholders.

 

Taxpayers failed to establish a debtor/creditor relationship using the following factors (Welch v. Comm. , 85 AFTR 2d 2000-1064):

(1) a note or other instrument,

(2) charging of interest,

(3) a fixed schedule of repayment,

(4) collateral,

(5) repayments actually made,

(6) a reasonable prospect of repaying by the borrower and sufficient funds to advance by the lender, and

(7) the parties conducting themselves as if the transaction was a loan.

[Knutsen-Rowell, Inc. , TC Memo 2011-65 (Tax Ct.)]

 

"Reasonable" compensation and a regular schedule of distributions to owners would go a long way to avoiding the trap that the Rowell's fell into.  This case is a reminder of how dangerous informality can be when a controlling shareholder borrows from a corporation. To avoid constructive dividend treatment, the owners of a corporation should observe the formalities when making their withdrawals. Whenever practicable, a withdrawal that's intended to be a loan should be documented as such, with a legally enforceable promissory note that pays sufficient interest, and the transaction should be reflected as a loan on the corporation's books and records. Further, repayments should be made in accordance with the terms of the note.

 

Only 26 Days left until 2010 tax returns are due...