The tax court recently gave another reminder of the importance of properly documenting shareholder loans, and making sure that they reflect economic reality. If they don’t, any attempt to deduct these loans as bad debts will be disallowed, causing financial and tax heartache for the lender-shareholder.
In Sensenig, TC Memo 2017-1, the court relied on three factors to determine that Sensenig’s loans to corporations were not debt, but equity. These factors included: (1) the form of the instrument; (2) the economic reality of the transaction as it relates to investor risk; and (3) the intent of the parties.
First, the form of the instrument, is a matter that I constantly focus on. In this case, there was no formal loan agreement nor were there any formal demands for repayment of the debt. Further, in many court cases, the court will state that even if there is a formal note, if there has not been interest or repayment of any principal within five years, it will automatically be considered equity and not a loan.
This critical factor is one reason why all corporate minutes should ratify and confirm loans between shareholders and their companies, as well as have a proper debt instrument in place. [perfectpullquote align=”full” cite=”” link=”” color=”” class=”” size=””]All corporate minutes should ratify and confirm loans between shareholders and their companies[/perfectpullquote]
The second fact, reality, is also important. In this case, no reasonable person would have loaned money to this high-risk borrower. A person would have only advanced funds if he took equity, because the risk of nonpayment was too high (and equity would give a higher rate of return).
The last factor, intent, is examined by evaluating the subjective thoughts of the parties. For the purposes of this discussion, I am going to ignore this part.
Even beyond these factors, the most glaring failure of the taxpayer in this case was that even after he had declared some loans as bad debts, he continued to lend money to the powers. This falls in the category of “dumb.” Even without the first three factors, when you continue to loan money to a borrower, you expect to get repaid; so how could you claim that prior loans were not going to get repaid?
The takeaway: If you are going to loan money to any company (including your own), make sure:
(1) it’s properly documented;
(2) the parties actually intend for the monies to be a loan and not equity; and
(3) other unrelated third parties would make similar loans on the same terms as you.
(4) don’t continue to loan money if you haven’t been repaid prior loans.
If you have any questions about documenting your shareholder loans or other matters regarding your business give me a call at 248-455-6500 or email me firstname.lastname@example.org