The amounts outstanding in each brother's account were reflected on the
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
auditors, reflecting the amount 'due' or 'payable' to the corporation. Throughout the period,
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
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
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
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
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.