Loans to employee-shareholders.

Unlike loan proceeds, dividends are taxable income. The IRS closely examines loans a corporation makes to an employee-shareholder--and scrutinizes the transaction even more carefully when the employee-shareholder owns a controlling interest in the corporation. For a loan to be genuine, both the lender and the borrower must intend that the debt be repaid.

The court examines the entire transaction to determine whether it is a loan; no one factor is conclusive. To determine whether both parties meant to treat the transaction as a loan, the court examines the borrower's ability to repay the loan, the amount of interest, whether there is a note outlining the repayment schedule and collateral for the loan and whether the borrower made repayments.

Nariman Teymourian, CEO and president of the board of directors of Capsian Corporation, owned 60% of the software-development company's stock. Although he did not execute a formal loan agreement, he used approximately $643,000 of the corporation's money to purchase a home in 1999 and received an additional $927,000 in 2000. The corporation listed both amounts as notes receivable on its balance sheet. During 2000 Teymourian repaid $448,000 of his debt to the corporation, and Capsian reported $48,000 of this amount as interest income. During the tax years 1999 and 2000 the corporation neither paid nor declared any dividends. The IRS reclassified the monies received as a dividend and assessed Teymourian a deficiency for 1999 and 2000. He petitioned the Tax Court for relief.

Result. For the taxpayer. The court examined the factors that distinguish a true loan from a disguised dividend. Three factors indicated the transfer in this case was a dividend: the lack of a formal loan agreement, a specific repayment schedule and collateral for the loan. However, during the period of time the loan was outstanding, both parties acted as if the transfer was a loan. Teymourian paid interest to the corporation ($48,000) and repaid a substantial portion ($400,000) of principal, and there was a reasonable prospect he would repay the entire loan.

The absence of a written loan agreement does not automatically mean money transferred from a closely held corporation to a majority shareholder is treated as a dividend. In this case the court examined the parties' actions after the transfer. However, to reduce the chance of having a transfer recharacterized as a dividend, taxpayers should formalize an agreement with a note and treat the transaction as a loan.

* Nariman Teymourian v. Commissioner, TC Memo 2005-232.

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