Take Care With Documenting Loans From Your Company

April 25, 2017

In a 2017 Tax Court case, the court found that payments from a corporation to its sole officers, a husband and wife, where the husband’s father had effective control of the corporation, were taxable income instead of nontaxable loans to the officers.

In Caiping Zang, et ux. v. Commissioner, TC Memo 2017-55, the taxpayers claimed that payments from the corporation of $2,274,269 received over three years were loans, while the IRS claimed the payments were taxable compensation. The court found that the taxpayers failed to maintain adequate records to document the payments were loans.

Citing applicable case law, the court stated that for a bona fide loan to exist, the parties must have had an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced, and that such an intent exists if the debtor intends to repay the loan and the creditor intends to enforce the repayment. The court then examined the following eight factors to determine the parties’ intent and whether a bona fide loan occurred (stating that no single factor is dispositive):

  1. the ability of the borrower to repay;
  2. the existence or nonexistence of a debt instrument;
  3. security, interest, a fixed repayment debt, and a repayment schedule;
  4. how the parties’ records and conduct reflect the transaction;
  5. whether the borrower has made repayments;
  6. whether the lender had demanded repayment;
  7. the likelihood that the loans were disguised compensation for services; and
  8. the testimony of the purported borrower and lender.

In running through these factors, the court found that all but one indicated that the payments to the taxpayers were not bona fide loans. Of particular note, the court found:

  • The taxpayers’ reported combined wage and rental income of approximately $524,000 over the three year period at issue was not enough for them to have reasonably expected to be able to repay the more than $2.2 million in purported loans they had received over that same period.
  • No contemporaneous promissory notes were drafted to memorialize the purported loans. The taxpayers later had executed one note, but it was 4-1/2 years after their first purported borrowing and also after the start of the IRS examination.
  • The after-the-fact note itself provided for no interest rate and no fixed schedule for repayment, nor was there any evidence of any legally enforceable security interest.
  • The parties’ conduct and what few records they kept of the transactions suggested that there was no intent that these were bona fide loans when the funds were advanced.
  • The taxpayers submitted evidence of only two purported loan payments made before the start of the IRS examination, only totaling $7000. The court found that payments made after the start of the examination did not show that the taxpayers intended a bona fide debtor-creditor relationship to exist at the time that they received the funds from the corporation.

Although the facts here may have been atypical, this case highlights the importance of properly documenting corporate loans to shareholders and related parties. Contemporaneous, written, loan documents help demonstrate the necessary good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced. Later actions, including after the fact documentation and loan repayments, can help demonstrate the intent, but actions taken after being contacted by the IRS may not carry much weight.

You can read more about the case here.

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