In a recent tax court decision, the courts again ruled that a loan made to a shareholder by a corporation was a taxable distribution to the shareholder and not a loan. We are thus reminded that it is always important for proper documentation to support all transactions between corporations and their shareholders.
In this case, the shareholder was an employee and the sole shareholder. He was also the president and director. While there was a loan agreement, it was not signed until six months after its creation. Moreover, even though the note provided for a market rate of interest, interest was not actually charged at the market rate. In addition, the taxpayer did not make any principle payments on the note.
The Court considered the following factors in reviewing the validity of the loan transaction:
• Is the promise to repay evidenced in the note?
• Is interest charged?
• Is a fixed repayment schedule established?
• Is there any collateral?
• Were repayments made?
• Does the borrower have a reasonable prospect of repaying the loan?
• Did both parties conduct themselves as if the transaction was a loan?
This case points out the importance of the details in a loan transaction especially when it involves related parties. In the case of a loan between a corporation and a shareholder, failure to follow the terms and provisions of the loan will likely result in the loan being treated as a taxable distribution. This is even more likely to be true when there is no written agreement or evidence of a transaction at all. It may not be enough to just have a loan document, following the provisions of the document are key to the transactions too.
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