Friday, September 23, 2016

Is It a Loan, A Contribution To Capital, or Shareholder Compensation?

William Delaney, EA
Westwood, MA
Your client “loans” money to his struggling business.  He may or may not receive repayments.  He does, however, pay personal bills out of the business checking account.  He can’t afford (or perhaps does not wish to) draw a paycheck.  Sound familiar?  We all struggle with the need to classify withdrawals.  Just what are they?
Loan repayments, advances to the shareholder, compensation which needs to be reported as payroll, or something else?

The Tax Court in Scott Singer Installations, Inc. v. Comm., T.C. Memo 2016-161 (8/24/16), has provided a very useful analysis of such activity by applying a concept which your editor constantly advocates---substance over form.  Read on…

In order to provide funds for his growing business (an S corporation), Mr. Singer established a personal home equity credit line in 2006; Within one year he had transferred $224,000 from that credit line to his corporation.  He also refinanced his home in 2006 (quite a trick---refinancing and equity indebtedness in the same year) and transferred $87,443 to his business.

A general business line of credit was established personally by Mr. Singer in 2008 and $115,000 was transferred to the business.  How you can established a “business” line of credit outside of the business, i.e. corporate, structure is not explained in the memorandum of facts, but it apparently happened.

Not to be outdone, Mr. Singer then borrowed $220,000 from his mother and her significant other (aka boyfriend) and transferred it to the business.  Altogether the transfers between 2006 and 2008 amounted to $646,443.  Perhaps our clients do not have the deep pocket resources of Mr. Singer, but we’ve seen the pattern of interwoven loans often enough.

During this “loan” period, the business was profitable.  However, by 2008 the business had gone into decline, so Mr. Singer relocated to Florida with high hopes for a business recovery.  Unfortunately, this did not happen.  Between 2009 and 2011, Mr. Singer poured money into the business to keep it afloat (sound familiar?).  He could not borrow commercially, but he could (and did) tap his mother and her boyfriend for another $513,099 which went into the business.

During the years 2010 and 2011, when the business was generating large losses, Mr. Singer began to tap into the business bank account and direct it to pay many of his routine recurring personal bills, such as a home mortgage and vehicle loan.

When the loans were deposited to the business, they were classified on the books and on the income tax returns as loans.  No formal loan documents were prepared.  Interest rates were not set.  Regular principal/interest payments were not made.  Isn’t this exactly what we see all the time?

The personal expenses, when paid by the business, were charged against the loan account.  Nothing was expensed on the books.  When the IRS came calling, they looked at what was going on and declared the personal expense payments of $181,872 to be wages subject to payroll tax.  The business did have payroll and was filing 941s, 940, etc.  While the shareholder/president worked full-time for the business, he did not draw a salary or receive wages to report on the payroll tax returns.

The Court was required to determine if Mr. Singer was an employee for purposes of FICA and FUTA (he was, and the taxpayer did not refute this finding), and if the personal expense payments (as the IRS maintained) were wages subject to FICA and FUTA (they were not, so read on with a sense of relief).

The Case cites authority (referred to as aids) for evaluating how withdrawal payments of this nature should be classified.  In Singer, the Court looked to “whether there was a genuine intention to create a debt, with reasonable expectation of repayment, and whether that intent comported with the economic reality of creating a debtor-creditor relationship.”  See Litton Business Systoms, Inc. v. Comm., 61 T.C. 367 (1973).

The IRS argued that the “loans” were actually capital contributions.  Using that reasoning, there would not be a loan account balance to be offset by the personal expense payments, so such payments should be income subject to FICA and FUTA.
The Court countered by referring to what it found to be “most pertinent.”  First, the Court found that the business had consistently classified the transfer activity as loans, both on the books and in the income tax returns.  This created a debtor-creditor relationship in the opinion of the Court.  Second, the Court determined that the personal expense repayments were ongoing and consistent (remember that many of the payments were for recurring monthly expenses, such as a mortgage and a vehicle loan).  The Court found this consistency to be “characteristic of debt repayment.”

Last, but by no means least, the Court found that the business made these payments even when it was losing money.  This strongly suggested to the Court that there was a debtor-creditor relationship both in good times and in not so good times.  The Court quoted from a taxation test to make its point:  “A fundamental difference between a creditor and an equity investor is that the former expects repayment of principal and compensation for the use of money, whereas the latter understands that the return of its investment, and any return on that investment, depend on the success of the business.”  [David C. Garlock, Federal Income Taxation of Debt Instruments, p. 1039-1040 (6th Ed. 2010)].

Not to jump with joy, however, because we have a complicated fact pattern of transfers and their relationship to reasonable expectation of repayment to deal with.  The transfers occurred over a period of years, some of which were profitable and some of which were not.  The Court looked at the time periods and determined that the advances of $646,443 between 2006 and 2008 occurred during a time of profitability and with reasonable expectation of repayment.  Looking ahead (beyond 2008) the Court expressed its opinion that “Mr. Singer should have known that future advances would not result in consistent repayments.”  This was the time period when Mr. Singer was rejected by commercial loan resources and borrowed $513,099 from his mother and her boyfriend.  “No reasonable creditor would lend to the petitioner…” (i.e. Mr. Singer).  Therefore, the Court classified this subsequent activity as a capital contribution.

The Court determined that the internal accounting treatment of the personal expense repayments was correct; they were repayment of loans.  However, the transfers after 2008 were reclassified as capital contributions.  Nothing was reclassified to W-2 wages.

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