If you own two or more companies -- or own a major interest in two companies -- you could be courting tax disaster if one corporation makes loans to another.
Let me describe what happened to a taxpayer who was a 74% shareholder in an automobile dealership and a 43% shareholder in an unprofitable Bahamian fishing corporation. He took $13,000 out of the dealership and advanced it to the fishing company in exchange for interest-bearing unsecured notes. He made additional advances, totaling $63,000, without any notes. Finally, the Bahamian company failed, distributing only $6,000 in assets to the taxpayer. The dealership received nothing and wrote off the advances as bad debts.
The IRS, later supported by the tax court, claimed that the advances were contributions to the capital of the fishing corporation made by the dealership on the taxpayer's behalf. It treated the advances as dividends and included them in the taxpayer's income.
The appellate court weighed 13 factors to determine whether the advances were debt (loans) or equity (contributions to capital):
1. the name given to the document evidencing the debt
2. whether the maturity date was fixed
3. ability of the debtor to repay
4. ability of the debtor to obtain a loan from a bona fide lender
5. whether the right of the lender to enforce payment was properly documented
6. the common shareholder's increase of control due to the loan.
7. subordination of advances to other corporate creditors
8. intentions of the parties
9. adequacy of the debtor corporation's capitalization
10. the proportion of the shareholder's interest in the corporations
11. the collection of interest on the debt
12. the use of the loan proceeds
13. timely repayment
Twelve out of the 13 factors characterized the advances as equity and not debt.
To avoid a similar problem, be sure that advances are well documented as having all the characteristics of loans. And the shareholder should be placed at arm's length from the transaction.