Many small businesses depend on infusions of cash from their owners in order to meet cash flow needs or finance expansion plans. The infusions can be nominal, such as small sums needed to meet an unexpected emergency, or can be substantial, as a way to start a business. How the advance is treated by the owner and the business impacts tax treatment. The IRS and courts apply heightened scrutiny to advances in the context of closely-held corporations.
Why it matters
The classification of the advance — as a loan or a contribution to capital — dictates how the repayment is treated for tax purposes for the shareholder:
- If it is a loan, then the repayment is tax free.
- If it is a contribution to capital, then the repayment may be treated as a taxable dividend to the shareholder or even as taxable compensation (which would also be subject to payroll taxes).
The classification also impacts whether the corporation can deduct interest payments on the advances: yes if it’s a loan and no if it’s a contribution to capital. From the corporation’s perspective, neither the repayment of principal on a loan or the payment of a dividend is deductible.
Facts and circumstances
Detective Joe Friday on Dragnet in the 1950s used to say: “just the facts, ma’am.” Whether an advance of money to your company is a loan or a contribution to capital depends on the facts and circumstances of the situation. Courts have laid out a number of factors that are used to assess the facts of a situation:
- 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;
- identity of interest between creditor and stockholder;
- 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.
Actions speak louder than words
In a case last year involving the issue of classifying advances to a closely-held corporation, the Tax Court said that the labels attached to transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless these labels are supported by other objective evidence. In the case, the fact that corporation made payments to the shareholder when it was operating at a loss strongly suggests a debtor-creditor relationship existed (i.e., advances were loans).
Recently, the IRS acquiesced in the result of the case, but only with respect to the issue of whether the corporation’s payments of personal expenses were wages subject to self-employment tax. This question arose because the shareholder’s advances to his corporation were loans repaid by means of covering his personal expenses; the corporation’s payments of his expenses were not taxable compensation.
If you can control the situation, is it better for your advances to be loans or contributions to capital? It depends on your situation. Consider how loans impact your balance sheet and your ability to obtain outside financing. Also consider the corporation’s debt-to-equity ratio. If equity is too “thin,” advances can’t be treated as loans. Discuss with your tax advisor any advances you’re going to make so you can take the steps to obtain the desired treatment.
The classification of advances to a closely-held corporation is all too-frequently litigated. You don’ want to be in the position of having to go to court to prove your point. Make sure you clearly indicate how you want advances to be treated. If you want to nail down classification as a loan, make sure you:
- Have a promissory note that includes repayment terms, including interest.
- Make sure the corporation follows the terms of the note, such as making timely repayments.
- Treat the advance consistently on all corporate papers, including the balance sheet. Enter the advance as a loan in the liabilities section of the balance sheet and not in the shareholder equity section.