Lending corporate cash to shareholders can be an effective way to give the shareholders use of the funds without the tax consequences of dividends. However, an advance or loan to a shareholder must be a bona fide loan to avoid being classified as a constructive dividend. Further, the loan must have an adequate interest rate to avoid being classified as dividends under the below-market loan rules of Sec. 7872.
What is Constructive Dividends?
Constructive dividends result in an unintended and unfavorable recharacterization by the IRS of a corporate-shareholder transaction as a dividend. All that is required for treatment of a transaction as a constructive dividend is a finding by the IRS that a shareholder received some benefit from the corporation.
The following are examples of potential constructive dividends:
- Payments made to others for the personal benefit of the shareholder.
- Payments to family members of shareholders that were in excess of the value of services the family member provided. Also, payments to a family member made on a lease that did not have a business purpose.
- Amounts paid to a shareholder in excess of what is considered reasonable, this may include not just salary but also directors’ fees.
- Loans to shareholders that is not a bona fide loan may be deemed to be a constructive dividend.
- Loans to shareholders at “below-market” interest rates.
- Use by shareholders of corporate property. This can include the use of corporate-owned autos, boats, airplanes, vacation homes, and other property if the value of such usage is not repaid or is not included in a shareholder-employee’s salary or wages.
- Improvements to shareholders’ property, including improvements made by the corporation to property leased from a shareholder that were in excess of normal lessee improvements.
- Assumption of shareholder debt by the corporation without adequate consideration or payments on such a debt, is classified as constructive dividend.
- Bargain purchases of corporate property by a shareholder: The difference between the FMV and the purchase price could be a constructive dividend.
Establishing a Bona Fide Loan
Nariman Teymourian got a real shock when, at the end of his IRS audit, the IRS claimed that he owed over $600,000 in taxes and penalties, primarily because he had received advances from the corporation in which he had majority control (Nariman Teymourian v. Commr., T.C. Memo 2005-232).
Teymourian was building a home. His corporation made big advances to him during the building period. However, the paperwork between Teymourian and the corporation was far from perfect and triggered the problems with the IRS.
If you own a C corporation, you must pay attention to the advances made by the corporation. When the IRS looks at the advances made to you, it makes one of two decisions:
- The advances are non-taxable loans to you
- The advances are taxable dividends to you
As you can see, there is a big difference between a loan and a dividend.
While Teymourian won his case, he had the displeasure of the IRS’s company in court. Here are seven magic questions you must be able to answer “yes” to ensure that your advances are treated as loans.
- Did you sign a promissory note or other document promising to repay the money to the corporation?
- Did you pay interest on the advances? (There are certain exceptions to imputing interest. The main exception is for de minimis loans, where the aggregate loans outstanding between the corporation and the shareholder does not exceed $10,000).
- Did you make payments on a fixed monthly, quarterly, or other schedule?
- Did you give the corporation collateral to secure your repayment?
- Did you repay the loan?
- Did the corporation check you out to make sure you had the ability to repay the loan (i.e. look at your credit report, net worth, etc.)?
- Did you and the corporation conduct yourselves as if the advances were loans?
Whether withdrawals from a corporation are loans or dividends depends on whether, at the time of the withdrawal, the shareholder intended to repay the amounts received and the corporation intended to require payment. It is not enough for a shareholder to declare that he or she intended a withdrawal to be a loan. There must be more reliable evidence that the transaction is in fact a loan.
Other factors the IRS uses in making their decision between loans and dividends:
- The extent to which the shareholder controls the corporation. If a shareholder has unlimited control of a corporation, it is likely that loans will not be arm’s-length transactions.
- The earnings and dividend history of the corporation. A corporation’s history of not paying dividends despite the existence of sufficient earnings and profits may indicate that loans to shareholders should be considered constructive dividends, particularly where other evidence of indebtedness is lacking.
- The magnitude of the advances and whether a ceiling existed to limit the amount. The lack of a ceiling limiting the amount a shareholder can withdraw from the corporation is indicative of a constructive dividend rather than a loan. In addition, sizable advances in relation to corporate profits or shareholder salaries may also be evidence that a distribution is not a loan.
- Whether there is a set maturity date. A fixed maturity date for a shareholder loan can be a strong indication that a true loan is intended. However, where term loans are regularly renewed without payment, with interest charges added to the note balance, little weight will be given to the maturity dates. Shareholder advances without set maturity dates can still be considered loans if other factors indicate that the arrangement is a true loan.
- Whether the corporation ever enforced repayment. Such action on the part of a corporation would indicate that a true debt arrangement exists. However, this factor is unlikely to be present in the case of controlled corporations.
Warning for S Corporation Shareholders
An S Corporation shareholder should not ignore the above recommendations. If the S corporation shareholder is not paid adequate and reasonable compensation, then it’s possible that all or a portion of the advances are actually wages not yet recognized. Here, employment taxes may come into play. Moreover, if the S corporation is already in a loss position for which there is no basis for the shareholder to take the increased loss, then income at the shareholder level occurs with no corresponding benefit of the entity-level deduction for the increased wages. These additional wages could also affect the company’s pension plan or workers’ comp premiums.
S Corporation shareholders could reclassify some or all of the balance of the “loan” as a non-taxable dividend distribution. However, simply awaiting a profitable tax year at which time the company records journal entries to reduce or eliminate the shareholder loan may be risky. A consistent practice of temporary loans that are later being adjusted does not assist in proving to the IRS the intent to pay back the debt at the time of the advances.
Careful attention must be given to distributions from the corporation to its shareholder. This is an area that the IRS will address during audits and it is up to the taxpayer to prove that the advances are loans, which has several tax implications. If it’s not truly a loan, the IRS could argue one of the following: 1) Are the amounts actually additional taxable compensation? This would result in an increased deduction to the company and increased ordinary taxable income to the owner-shareholder subject to employment taxes or 2) Are the amounts actually a constructive dividend? Here, the result is potential taxability as ordinary income or capital gain.