When individuals who are shareholders in corporations (especially closely held corporations) must provide their companies with additional funds, they should identify the potential consequences; the manner in which such advances are made will affect their tax treatment (especially if the corporation is unable to repay the funds).
DEBT VERSUS CAPITAL CONTRIBUTIONS
The first thing to determine is whether a shareholder’s advance to a corporation was a valid debt that he or she expected to be repaid in the future or a contribution to the corporation’s capital.
In making this determination, the primary factor is the parties’ intent. While this can be a very subjective determination, these objective factors are considered:
* How the transaction was accounted for on the business’s books.
* The existence of a written agreement between the shareholder and the corporation.
* Whether the company paid interest, and whether the shareholder reported interest income.
* Whether repayment was contingent on company earnings.
* Whether the debt was subordinate to (or included with) that of other general creditors.
* The corporation’s level of capitalization.
Business bad debts. Individual taxpayers may deduct two different types of bad debts: business bad debts, which are deductible as ordinary losses if completely or partially worthless, and nonbusiness bad debts, which are short-term capital losses taken only when entirely worthless. A business bad debt arises from a debt created or acquired in connection with a taxpayer’s trade or business, or from the worthlessness of a debt incurred in the taxpayer’s trade or business. All other bad debts are nonbusiness.
Business versus nonbusiness bad debt. Once a debt is determined to be bona fide, it must be determined whether the debt is business or nonbusiness. A debt is classified as a business bad debt if the taxpayer is engaged in a trade or business and, at the time the debt was acquired, created or became worthless, the debt was proximately related to that trade or business (there must be a dominant business reason–and not merely a significant one–for the loan).
TRADE OR BUSINESS REQUIREMENT
Since devoting one’s time and energies to a corporation’s affairs is not in and of itself a trade or business, a shareholder generally is not considered as being in the same trade or business as his or her corporation. However, if shareholders can establish that they made loans to their corporations in the course of a trade or business (for example, as an employee, in the business of money lending, in the business of acquiring and promoting corporations or in some other commercial relationship), this requirement may be met.
Employee. To satisfy the dominant motivation standard, a corporate employee must show that a loan to the company was made to protect his or her salary and position as an employee. If the employee has no equity interest in the corporation, the motive for making such a loan should be clear. If the company is asking its employees to make equity investments or to guarantee business loans, such loans or guarantees still clearly can qualify if protection of the employee’s position remains the dominant motive for the advances. Factors considered when determining the dominant motive for a loan or guarantee include
* The employee’s level of investment in the company.
* The level of salary received.
* The amount of the loan or guarantee in relation to the employee’s investment or salary.
* The employee’s income from other sources.
* The size of the employee’s investment relative to his or her salary.
* The percentage of the employee’s ownership interest in the corporation and any relationship to those owning the remainder of the company’s stock.
* The employee’s ability to find employment elsewhere.
For a detailed discussion of these issues, see “Arguing the Case for a Business Bad Debt Deduction,” by David Zinneman, Linda Johnson and David Webster, in the August 1994 issue of The Tax Adviser.