Cash advances to a corporation: loan or capital contribution?

When cash is transferred to a closely held corporation, is the transfer a loan or a capital contribution? The transfer is treated as a loan if there is an unconditional obligation to repay it. When there is a dispute, the courts look at factors such as the presence or absence of a written note, scheduled payments, a fixed interest rate, interest payments, collateral and a sinking fund. In addition, courts examine the corporation's use of the transferred funds, its capital structure and its source of funds to make repayment.

Indmar Products Co. is a closely held corporation that manufactures marine engines. From 1987 to 2000 the shareholders made cash advances to the corporation in amounts ranging from $634,000 to $1.7 million that it reported as liabilities on its balance sheet. Indmar, in turn, made regular monthly interest payments to the shareholders based on an annual interest rate of 10% and also repaid various amounts to them. The shareholders reported the interest income from the advances on their individual tax returns while the corporation deducted the interest payments. The IRS denied the interest deductions on Indmar's 1998 to 2000 tax returns and assessed a deficiency of $123,735. The taxpayer petitioned the Tax Court for relief.

The Tax Court ruled the advances were not loans because they were unsecured, were demand notes with no fixed maturity date, lacked an unconditional obligation of repayment and would not be repaid unless Indmar recorded a profit. Furthermore, Indmar had not paid any dividends or created a sinking fund from which to repay the advances. The taxpayer appealed the decision to the Sixth Circuit Court of Appeals.

Result. For the taxpayer. The Appellate Court applied the Roth Steel factors (Roth Steel Tube Company v Commissioner, 800 F2d 625) that it had developed in a prior debt/equity decision and, in a split decision, determined that the Tax Court bad ignored some of those factors and misapplied others. Specifically, the Sixth Circuit ruled that the Tax Court had erroneously focused on the shareholders' intent when they structured the advances as loans rather than giving proper weight to the fact that the advances had a fixed, reasonable interest rate that was used to make regular interest payments.

The court also disagreed with the Tax Court's holding that the absence of written instruments between 1987 and 1992 indicated there was no unconditional and legal obligation to repay the advances, noting the existence of written notes for all years after 1992, which the Tax Court ignored. In addition, the Sixth Circuit disagreed that the demand notes represented equity because of the lack of a fixed maturity date. It said that a loan requires an ascertainable maturity date--which a demand note has--not a fixed maturity date, and the Tax Court's interpretation would disqualify shareholders from using a common type of commercial loan. The court also said the Tax Court had ignored the credible testimony of one of the company's shareholders that he fully expected to be repaid the amounts he had advanced to Indmar.

Finally, the Sixth Circuit gave little weight to Indmar's lack of a sinking fund and collateral since the company was not highly leveraged. The absence of dividend payments during the years in question also was not considered significant because the shareholders had been advancing money to Indmar at that time in addition to receiving interest payments. Also, the amount of interest paid on the advances was based on a reasonable rate; an unreasonably high rate of interest would have indicated a disguised dividend.

This case emphasizes that shareholder advances to a closely held corporation will be treated as loans if the characteristics of the agreement are similar to those for loans made to the corporation by an unrelated party (For background information on the lack of guidance regarding debt vs. equity, see From the Tax Adviser, page 76.)

* Indmar Products Co. v Commissioner, 444 F3d 771.

IRS Updates the "Dirty Dozen"

People involved in these tax schemes can be subjected to hefty fines or even jail time.

* Zero wages claims.

* Form 843 tax abatement scams.

* Phishing.

* Zero return fraud.

* Trust misuse.

* Frivolous arguments.

* Return preparer fraud.

* Credit counseling agency fraud.

* Abuse of charitable organizations and deductions.

* Offshore transaction scams.

* Employment tax evasion.

* "No gain" deduction scams.

Source: IRS, www.irs.gov/newsroom/article/0,,id=154293,00.html, 2006.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.