Whenever cash or property passes between a closely held corporation and its shareholders, there are generally tax consequences. You can control the consequences by documenting your intentions for the transactions and by following through accordingly.
For example, let’s say a shareholder takes withdrawals from a corporation’s accounts that are intended as tax-free loans — but they aren’t properly documented. In an audit, the IRS will likely recharacterize them as constructive dividends with capital gains tax due.
The IRS and courts examine a number of factors to determine if payments to a shareholder are proceeds from a tax-free loan or a taxable corporate distribution. Some questions:
- Was there a written promise to repay the loan evidenced by a note or other document?
- Was there a stated interest rate, repayment schedule or balloon repayment date?
- Were principal and interest payments made on time?
- Was there adequate security or collateral for the loan?
- Did the borrower have a reasonable prospect of being able to repay the loan?
- Did the parties conduct themselves as if the transaction was a loan? For example, did the shareholder show loans owed to the corporation as liabilities on his or her personal balance sheet?
When transactions are intended to be loans, the factors above should be considered and respected. Otherwise, the IRS could recharacterize the transactions in ways that have negative tax consequences for shareholders, their corporations, or both.
Properly structuring corporate loans is critical to getting the best tax and financial results. Contact us for assistance plotting the best strategy.
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