(Part 2)
SHAREHOLDER loans accumulate over time and become red flags for IRS audits. Left unchecked, they grow to sums that are hard to repay. Let’s discuss some tips and developments.
Here are Tips to Alleviate this Problem: Make some payments, even a small amount from time to time. This indicates the existence of a true loan. Successful defenses on IRS audits have identified the key to winning on this issue: Repaying the loans in full occasionally. Use a credit line, borrow from your credit card, and raise funds from anywhere to pay-off at the end of the year. I have personally found out through audits (that I have defended) that some repayments and a subsequent valid effort to enforce repayment have saved the day for some seemingly lost cases. I also had to contend with a typical IRS approach to loans to family members as a two-step transaction: First, as a dividend distribution from this corporation to the shareholder and, second, as a loan from the shareholder to the family member. The shareholder, not the corporation, is stuck with a non-business bad debt and has to pick up dividend income. The IRS may also argue that if it is a non-business bad debt at the corporate level, there is no corporate deduction for the loss because it is not an ordinary and necessary business loss.
In conclusion, shareholder loans become an issue on IRS audits when they are converted to constructive dividends. This problem is caused by shareholders getting loans and failing to conduct these transactions at arm’s length. The lack of formality in dealing with these loans is the usual culprits for losses at IRS audits. It is not so bad when the loans are converted to salaries because such wages are deductible by the corporation and, therefore, offset the tax effect of picking up the income on your individual income tax returns.
Here’s the Solution: Clean up your books by formalizing the transaction and substantiating the loan arrangement by preparing promissory notes, demand letters. Create a regular and systematic repayment schedule of outstanding loans. If you have the funds, pay off the loan balances at the end of the year. If you do not have the resources, borrow, pay it off and after some reasonable period of time, re-borrow and pay back your sources. Sit down with your tax adviser and plan to clean up before the IRS comes calling. Do not forget to include such borrowings in your corporate minutes. Good Luck.
Development 1: IRS has stepped up scrutiny of shareholder loans and compensation. Compensated corporate officers are statutory employees for federal income tax withholding, FICA, and FUTA. This means that the only way to compensate a corporate officer is as an employee. IRS agents examine all payments to officers – loans, dividends, draws, and distributions.
Development 2: EDD (Employment Development Department of California) is also on the lookout for S corporation shareholders who take little or no salary. California conforms to federal law that payments to shareholders who perform services for the corporation but do not receive a salary for services – are wages, not distribution of earnings and profits that could qualify for the special 15 percent rate on dividends.
Development 3: Beware – Criminal investigations increased 8 percent the other year. Over 90 percent of indictments resulted in convictions. Traditional tax evasion cases make up 50 percent of cases. IRS hopes to increase time spent on unreported income to 70 percent.
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Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.