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DETERMINING THE BASIS OF GIFT PROPERTY

 

        Loans or Dividends         

Making loans to or taking a loan from a corporation where you're a stockholder can lead to tax trouble. In one particular tax case, the taxpayer 'borrowed' money from his regular corporation to finance his investment in a nearby ski area. The corporation was a manufacturer of soft drinks and the case was on appeal from a Tax Court decision that was unfavorable to the taxpayer. Some of the reasoning is from the Tax Court; some from the Court of Appeals.

The taxpayer owned 20.43% of the corporation's stock; the taxpayer's three brothers each owned similar shares; the remainder was held by the company's profit-sharing plan.

The four brothers each maintained an 'Officer Loan' account at the corporation, which reflected their discretionary withdrawals of corporate funds for their own use. Each brother was permitted to withdraw whatever amount he deemed appropriate, without prior authorization from one another or anyone else. 

The taxpayer borrowed significant sums from the corporation to finance his investment in a nearby ski area.

 

The amounts outstanding in each brother's account were reflected on the corporation's certified financial statements as accounts receivable from corporate officers (as current assets) and on the corporation's tax returns as loans to stockholders. 

The brothers executed no promissory notes, pledged no collateral, and undertook no loan repayment terms or interest obligations, though each brother annually submitted a confirmation letter to the corporation's auditors, reflecting the amount 'due' or 'payable' to the corporation. Throughout the period, the corporation declared no dividends.

The issue was whether the withdrawals by the taxpayer were bona fide loans, or distributions taxable as dividends. Whether the withdrawals are loans or distributions depends on whether, at the time of the withdrawals, the shareholder intends to repay the amounts received and the corporation intends to require payment. 

To that end, the Court examined all the facts and circumstances surrounding the withdrawals. The Court noted that other courts have considered various factors in arriving at a decision in such cases. None of the factors, alone, is determinative. The factors include:

  • The extent to which the shareholder controlled the corporation.
  • Whether the corporation had a history of paying dividends.
  • The existence of earnings and profits.
  • The magnitude of the advances and whether a ceiling existed to limit the amount the corporation advanced.
  • How the parties recorded the advances on their books and records.
  • Whether the parties executed notes.
  • Whether security was provided for the advances.
  • Whether there was a fixed schedule of repayment.
  • Whether interest was paid or accrued.
  • Whether the shareholder made any repayments.
  • Whether the shareholder was in a position to repay the advances.
  • Whether the advances to the shareholder were made in proportion to his stock holdings.

The Courts looked at a number of the factors cited above, and some special considerations.

First, while the Courts recognized the fact that transactions of closely held corporations are frequently characterized by informality, the size of the loans ($462,000 for one of the years) went far beyond what would be expected as informal loans. 

Thus, while one might escape unscathed where a poorly documented shareholder loan amounts to $5,000, the Court could not look askance at a loan 100 times that size, especially where there were no notes, no set maturity date or event of default which would require the taxpayer to remit the funds at a certain time, no ceiling on the amount that could be borrowed, and where the taxpayer pledged no security for the advances.

The Court looked at the issue of repayment, noting that repayment is usually strong evidence that a withdrawal is a loan. In this case, however, the waters were muddied by the fact that the taxpayer could 'repay' advances with additional borrowings or by crediting his year-end bonus against his loan account.

The Court looked to see if the taxpayer had the capacity to repay the advances. The taxpayer asserted he would make repayment out of the cash flow of the ski area. The Court found that rather than being a source of cash, the ski area was a sinkhole.

The taxpayer asserted that the advances were not in proportion to the stock ownership of the corporation. The Court said that it is well settled that a disbursement of corporate earnings to a shareholder may constitute a dividend to such shareholder notwithstanding that it is not in proportion to stock holdings or that some shareholders do not participate in its benefits.

Finally, the taxpayer contended that the corporation was forced to couch the distributions to the taxpayer as loans since, pursuant to the terms of a loan with the Small Business Administration, the corporation was prohibited from paying salaries in excess of $15,000 or any dividends. The Court found that the SBA was no longer enforcing this restriction as to salaries.

The Tax Court and the Court of Appeals both sided with the IRS, finding the amounts to be dividends. Of course, the issue here was that the taxpayer might have carried his case if he had followed some formalities. In fact, had he observed the formalities, he probably would have avoided going to court.

Set up a formal note; then make sure you stick to it. Put up collateral; pay interest. You should set up a repayment schedule that you can stick to. However, if you have to deviate, renegotiate the loan. If you set up a loan and don't state interest, the IRS will impute it.

A final note: S corporations may avoid some of the problems associated with constructive dividends. That is, if the corporation has always been an S corporation, should the distribution be a 'dividend' it would not normally be taxable. However, there are other issues with respect to S corporations. The distribution would reduce the shareholder's basis in the corporation. If the basis is reduced to zero, additional distributions would be taxable.

 

 

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