In Scott Singer Installations, Inc., (TC Memo 2016-16, filed August 24, 2016)1, the U.S. Tax Court (the “Court”) ruled that the bulk of payments made to a sole shareholder of an “S” Corporation, characterized as reimbursement of “personal expenses”, represented loan repayments. The Court held that the advances made by the shareholder to the business were loans rather than capital contributions. Therefore, the payments made by the corporation to him for those “personal expenses” were not wages subject to federal employment tax.
Characterization of transfers by shareholders to corporations, as either loans or capital contributions, is made by reviewing the evidence with the burden of proving that a transfer is a loan falls on the taxpayer. (Dixie Dairies Corp., 74 TC 476 (1980))
A variety of factors may be considered by courts in determining whether or not a loan has been made. “Such factors include: (1) the names given to the documents that would be evidence of the purported loans; (2) the presence or absence of a fixed maturity date; (3) the likely source of repayment; (4) the right to enforce payments; (5) participation in management as a result of the advances; (6) subordination of the purported loans to the loans of the corporation’s creditors; (7) the intent of the parties; (8) identity of interest between creditor and stockholder; (9) the ability of the corporation to obtain financing from outside sources; (10) thinness of capital structure in relation to debt; (11) use to which the funds were put; (12) the failure of the corporation to repay; and (13) the risk involved in making the transfers.” (Citing Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 285 (1990)
None of the factors is solely controlling or entitled to more weight than any other. According to the Calumet decision, the ‘”real issue for tax purposes has long been held to be the extent to which the transaction complies with arm’s length standards and normal business practice.”’ (Citing Estate of Mixon v. United States, 464 F.2d 394, 403 (5th Cir. 1972)). “However, the ultimate question is whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. (Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973))
Richard Singer was the sole shareholder and president of an S corporation called Scott Singer Installations, Inc. (the “Corporation”), and served as its sole corporate officer and worked full-time at the Corporation.
Between 2006 and 2008, Mr. Singer obtained funds for his business from various sources and advanced the same in a total of $646,443 to the Corporation for business development. The Corporation struggled from 2009 to 2011 and Mr. Singer borrowed another $513,099 from a family member and her friend, which he advanced to the Corporation. Mr. Singer also began charging business expenses to personal credit cards. The Corporation reported operating losses of $103,305 for 2010 and $235,542 for 2011. During these years, the corporation paid $181,872 of Mr. Singer’s personal expenses by making payments from its bank account to Mr. Singer’s creditors.
All of the advances by Mr. Singer were reported as shareholder loans on the Corporation’s books and its tax returns. There were no promissory notes between Mr. Singer and the Corporation regarding the advances; there was no interest charged on them; and there were no maturity dates imposed on them. The Corporation did not deduct the payment of Mr. Singer’s personal expenses on its tax returns.
The Corporation filed Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return) and Forms 941 (Employer’s Quarterly Federal Tax Return) and paid employment taxes on wages paid to each employee of the Corporation except Mr. Singer (the Corporation did not report paying wages to Mr. Singer during 2010 or 2011).
The IRS determined that Mr. Singer was an employee of the Corporation for 2010 and 2011 and that the $181,872 in payments the Corporation made on his behalf constituted wages that should have been subject to employment taxes. Mr. Singer did not object to being classified as an employee of the Corporation, but contended that the advances that he made to the Corporation were loans and that the payments the Corporation made on his behalf represented repayments of those loans. IRS, on the other hand, argued that the funds advanced to the Corporation were contributions to capital and the payments made for “personal expenses” amounted to wages.
The Court concluded that Mr. Singer intended his advances to be loans, that his intention was reasonable for a substantial portion of the advances, and that the Corporation’s repayments of those loans were valid and should not be characterized as wages subject to employment taxes.
As discussed above, the Court stated that there were a number of factors involved when evaluating the nature of transfers of funds to closely held corporations. However, the ultimate question was whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. If there existed a genuine intention to create a debt, the corporation’s payment of Mr. Singer’s personal expenses could be considered as partial repayment of Mr. Singer’s loans rather than as wage income.
The Court noted that the Corporation consistently reported the advances as loans on its general ledgers and on its tax returns and it consistently reported the expenses it was paying on behalf of Mr. Singer as a repayment of shareholder loans rather than reporting the payments as deductible business expenses. The Court ruled that this indicated that Mr. Singer and the Corporation intended to form a debtor-creditor relationship and that the Corporation conformed to that intention. In addition, the Court pointed out that the Corporation’s payments on behalf of Mr. Singer were consistent regardless of the value of the services Mr. Singer provided to the Corporation. Many of the payments the Corporation made were for Mr. Singer’s recurring monthly expenses, including home mortgage and personal vehicle loan payments. The consistency of these payments, both in time and in amount, was characteristic of a debt repayment. Furthermore, the fact that the Corporation made payments when it was operating at a loss strongly suggested that a debtor-creditor relationship existed: a creditor expects repayment of principal and compensation for the use of money, while an investor understands that any return upon investment depends on the success of the business.
The Court also noted that Mr. Singer had a reasonable expectation of repayment of the advances when he first advanced funds to the Corporation between 2006 and 2008. At that time, the business was well-established and successful. The Court believed that because the Corporation was operating profitably and showed signs of growth, Mr. Singer was reasonable in assuming his loans would be repaid and that such intention comported with the economic reality of creating a debtor-creditor relationship.
The Court, however, did not believe Mr. that Singer had a reasonable expectation that the loans he made after 2008 would be repaid as the Corporation’s business had dropped off sharply. It therefore concluded that the advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were capital contributions.
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