Tax Court: Dealing with Shareholder Loans
As tax pros, we are reminded by a recent Tax Court case that a shareholder that owns different companies, can be dangerous with informality when a controlling shareholder borrows from a corporation.
This was clearly evident on the case of Povolny Group TC Memo 2018-3. We all know, or should know, that if a controlling shareholder owns more than one company and makes inner-company loans, or takes a loan themselves, the loans need to have a promissory note that is legally enforceable.
According to Benson v Commissioner TC Memo 2004-272, dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation confers a benefit on a shareholder by distributing available earnings and profits without expectation of repayment. A transfer between related corporations can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds
In Welch v Commissioner TC Memo 1998-121, in determining whether a corporate distribution to a shareholder is a non-taxable loan. As is sometimes claimed, courts have analyzed a number of factors, such as whether:
- the promise to repay was evidenced by a note or other instrument; interest was charged
- a fixed schedule for repayment was established; collateral was given to secure payment repayments were made
- borrower had a reasonable prospect of repaying the loan and lender had sufficient funds to advance the loan
- the parties conducted themselves as if the transaction was a loan.
I know that I have put this in writing to my clients, but very few listen. Here are the facts of the case, and it boils down to, pigs get fatter, hogs get slaughtered:
James Povolny owned 49% of Archetone Limited, a general contracting firm operating as an S corporation, and his wife owned the other 51%. Povolny also was the president, CEO, and sole shareholder of Povolny Group (PG), a real estate brokerage firm. Finally, Povolny was also the sole owner of Archetone International, LLC.
In 2010, Povolny caused PG to make payments totaling $70,000 of Archetone Limited’s and Archetone International’s debts. On its ledgers, PG later listed this amount as being owed to it.
But, on its 2010 initial and amended tax returns, PG claimed the amount as a cost of goods sold (COGS). And because PG was apparently making money—on each of its returns it listed more than $879,000 in gross receipts—there was enough income to make the claimed COGS valuable.
In 2011, PG paid Povolny over $77,000, which he used to pay more of Archetone International’s debts. PG’s ledgers characterized these payments as “distributions.”
PG itself also directly paid another nearly $74,000 of Archetone Limited’s and Archetone International’s expenses, which PG’s ledger simply called “Archetone Payments.” That year, PG filed its tax return as an S corporation, reporting over $1 million in gross receipts, with $316,000 in ordinary business income flowing through to the Povolnys.
On their joint return for 2011, the Povolnys claimed an over $290,000 flow-through loss derived from a $241,000 bad-debt deduction that Archetone Limited took for payments it made on Archetone International’s behalf from 2005 to 2008 and a $74,000 deduction that it took for “Loss on Archetone International Expenses Paid.”
IRS denied all of the Povolny’s deductions and treated PG’s payment of $70,000 to Archetone Limited and Archetone International as a constructive dividend paid to Povolny. IRS also disallowed their claimed $290,000 flow-through loss.
What is obvious, is whomever represented this taxpayer, handed over the client’s QuickBooks File, which is the stupidest thing that you can ever do. We make adjustments to the file at tax time, I print a year-end cumulative general ledger.
If asked for a QuickBooks File by the IRS, I would argue that the client could have gone back and made changes to the file. I would then mention the financial statements, and the cumulative general ledger that I used to prepare the return.
Secondly, there is no note associated with these inner-company loans. The taxpayer has the audacity to take a $290,000 bad debt for the “loan.”
Lessons to be Learned
To be a bad debt, you have to first prove that something was owed, then you have to prove that aggressively tried to collect the money. This is a self-created bad debt. Technically, if we are going to call it a bad debt and write it off on one company, it would be income to the other company.
In this business, we need to dot our “i’s” and cross our “T’s.” The lesson is NEVER EVER hand over a client’s QB file to any government agency. They have no right to that info. Secondly, if there is a bona fide loan, have a lawyer draw up a promissory note. And CERTAINLY don’t write off a bad debt for a self-created debt.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...