S-Corp loans from shareholder

[natiro]

Client owns a restaurant and at 12/31/05 has 270,000 in loans to S-corp on books with debt basis of 210,000. During a typical year, shareholder will usually loan more $ to corp and will take distributions agains the loan. . .but never on a regular basis. There has never been any real tracking of the loans and there has never been any interest paid or imputed. This is a new client to me. This is a cash basis taxpayer, except for inventory.

I'm curious to hear how other preparers would handle this situation, specifically regarding the increases and decreases during the year and interest payments (or lack thereof.) Would you use some sort of amortization schedule to impute interest when actual payments are made? Assuming we'd classify this as a demand loan (since regular payments are not made) I believe we'd have to impute interest at the end of the year, which would increase his equity and would be a wash on his 1040. Is this correct? Let's say he loans $1,500 on 4/1, $800 on 6/1, $1,200 on 7/1, $2,000 on 8/1, $300 on 8/15, etc. . . would you write up separate notes everytime he makes a loan? Seems like a lot of effort to me but it would appear from the regs that each would be considered a separate loan.

Other perinent info: this is a sole shareholder and the interest in the business is nonpassive (he's the chef).

Thanks for your help, as always.

[Bees Knees]

Since your client isn’t really drawing up loan documents or charging interest, you might just treat all contributions as capital contributions, and all re-payments as distributions. I assume the distributions will never exceed total contributions so there would be no taxable gain issues.

If this were a C corporation, the IRS would reclassify all loans as capital contributions and all distributions as taxable dividends, coming from E&P. They would do that under the constructive dividend rules because the taxpayer isn’t following formal procedures…such as having a formal written loan document specifying an interest rate and repayment schedule.

I would think if the IRS can do that to a C corporation, then why can’t you do the same for an S corporation, where there is no negative side effect? This can only work when it is a 100% S corp shareholder, because if there were any other shareholders involved, you would not want to be treating all of these as capital contributions and distributions. But since it is a one man show, I don’t see any negative side of doing it this way.

[OldJack]

toilet paper

If the total of all the loans at any given date are less than $10,000 then interest is not required and the note documentation could be as simple as the words IOU on a piece of toilet paper.

Edit: well.... I forgot to read all the original post where the balance of loans is large. Duh!

[JG EA]

Question on part of your answer.

Since your client isn’t really drawing up loan documents or charging interest, you might just treat all contributions as capital contributions, and all re-payments as distributions. I assume the distributions will never exceed total contributions so there would be no taxable gain issues.

.... But since it is a one man show, I don’t see any negative side of doing it this way.

So, (and pardon how dumb this question is) would the paid-in capital just keep going up on the balance sheet year after year?

[Bees Knees]

So, (and pardon how dumb this question is) would the paid-in capital just keep going up on the balance sheet year after year?

Yes, unless you run your retained earnings account into the whole. Distributions generally come from your profits, but if you have losses, or distribute all of your profits, you would then need to take distributions from another equity account, such as paid in capital.

I show distributions on the balance sheet as a contra equity account for the current year only, and then close it into one of the other equity accounts at the end of the year. That way the balance sheet reflects the current year total distributions only.

[OldJack]

Personally, I would just document a new interest note at the end of each year for the balance. I think it would look strange for a financial report to have paid-in-capital to be changing. Also, for a return of capital a 1099-DIV, box 3, has to be issued even though it might not be taxable.

[Bees Knees]

S Corporations report distributions on the K-1, line 16, item D. The instructions for Form 1099-DIV says that S Corporations only report distributions as dividends on Form 1099-DIV when they come out of accumulated earnings and profits. Box 3 is for nondividend distributions, where Form 5452, Corporate Report of Nondividend Distributions is required. Form 5452 says that an S corporation should file this form only for distributions made under Section 1368(c)(3), which is the code section dealing with distributions made by an S corporation that exceed earnings and profits. If the S corporation never had any earnings and profits, it is not going to have any distributions exceed E&P, thus it is not necessary to use Form 5452, or Form 1099-DIV, box 3. That is what the K-1 is for.

[OldJack]

Bees, you should review the "ordering rules" on page 19-9 of TTB. For an S-corp return of capital is #4 and therefore leaves the "paid-in-capital" account on the books without change/ reduction unless the AAA account has been zeroed with property distributions. Just because a corporation elects S-corp status does not change the fact that it is a corporation with capital where stock can be redeemed, reorganized, capital returned, and complete or partial liquidation regardless of A&E. These mentioned items do not usually come under the heading of "property distributions", rather follow the same reporting rules as a C-corp even though there may or may not be a tax effect.

I disagree with the concept of capitalizing loans unless the 100% shareholder does not wish to receive the capital back until liquidation of the corporation. The capitalizing of the loan is a drastic solution to writing a simple demand note documenting the balance of a loan. If we accountants/preparers can't handle and calculate simple interest we should not be doing taxes.

[Bees Knees]

I agree that doing things the proper way with loan certificates is the way to go. I never said they shouldn’t treat them as loans.

The issue here is one too common…that is one man operations where they incorporated for some strange reason where there is no chance they will ever follow proper procedures. You can lecture people like this all day long. The fact is, some are not capable of following proper procedures, and no amount of barking on our part will get them to change.

Given this fact of reality, then what do we do? Do we pretend they do what we think they should have done? Or do we treat the transaction like it truly is?

Does this sound like loans to you? Not to me.

In Brazoria County Stewart Food Markets, Inc. v. Commissioner, KTC 2002-323 (5th Cir. 2002), the court said the following: “Distinguishing true loans from capital contributions is difficult because debt and equity are not mutually exclusive categories. Instead, "pure debt and pure equity lie at different ends of a spectrum with any number of variations in between." Any given investment may have characteristics of both debt and equity. It is not surprising, therefore, that in this case the government emphasized certain characteristics of the Brazoria-UPE transaction which were equity-like, while Brazoria emphasized those characteristics which were debt-like. In Estate of Mixon, we developed a thirteen-factor analysis to help evaluate whether a given investment should be treated as debt or as a capital contribution. The factors are: (1) the names given the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) subordination; (7) the intent of the parties; (8) "thin" or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) payment of interest only out of dividend money; (11) the ability to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the corporation to repay on the due date.”

Now I agree that the shareholder should loan the corporation money and have the corporation pay back interest. But given the tests mentioned in this court case and the reality of how this taxpayer runs his business, I think the court would conclude it is capital, not debt. And I doubt you are going to get this guy to follow the proper procedures required to make it debt.

[Gretel]

Yep. This is a very difficult subject dealing with reality. In one of my S-Corps. I have a mix of documented loans, loans from a second company of the owner, short term withdrawals and contributions and so on. In short, whereever is easiest to take the money needed for expansion, this is what will be done. The ideas always bigger than the cash flow.

I personally believe that there will be quite some profits in the future, but in the present the money is short. 10,000's, 100,000's, 1,000,000's, who cares, with a creative mind there is no end and I will not be able to tame the owner.

Often, money but into the company, is to reimburse for payments made through the company for buildung a privately owned rental. (Only so far as profits were not sufficient to cover the expenses, not a dollar for dollar reimbursment. Would be nice though.) Each month a journal entry for debits and credits on the rental to take if off the balance sheet.

Would be interesting would a court would say to all the transactions.

[OldJack]

Its not our call

Does this sound like loans to you? Not to me.

I agree the client don't always understand or do what we would like with transactions. What it "sounds like" is not up to me to decide if I can ask the client. If you explain the difference between a loan account and a capital account to the client he will most likely say he is making loans to the corp as he is not dumb as he wants it back later when the corp has the money. The client does not have to have an attorney to draft a promissory note. Such blank documents can be purchased in bulk through an office supply store, so how difficult is it for the tax preparer to point out the amount that needs to be written on the blank form. Personally, I think it would be going beyond our professional authority to decide to capitalize such transactions without the approval of a knowledgeable client that understands why it is being done.

[Bird Legs]

C or S Corp.

Was attending a seminar several years ago regarding corporations.
Speaker said he had client come in and talk with him about incorporating.
Client said that since he would be the only shareholder, that he could do just
about anything he wanted to in that corp.
Speaker said, yes you are correct.
However, my fees to keep you out of trouble with the IRS will fund my early retirement.

[S T]

And the Clock Ticks On

Well spoken, Bird, Shareholders/Owners have no idea what we go through to track their distributions and loans, etc.

Sandy

[natiro]

S-Corp loans

Very interesting discussion. Thank you for all the view points.

I guess for me it all boils down to this question: in a sole shareholder s-corp, where the activity is not passive, is there any difference between reporting imputed interest deemed paid and not doing so? My client had been advised that reporting imputed interest would increase his basis. I just don't see how this is so. . . reporting imputed interest deemed paid at the end of the year would increase his equity (deemed capital contribution) but his equity would be offset by the same amount for interest expense. There would be no effect on his personal tax return because the interest expense taken by the s-corp would be offset by the interest income reported. So in this case (sole shareholder, not passive), I don't see any effect one way or the other in not reporting the interest. Am I missing something obvious here?

In my original question, I asked whether you would document each loan separately. Per my research, it would appear that each loan should be a separate loan but I was wondering if anyone really does that in the real world, or if a year end note would work. Given my thoughts noted above, about whether the interest really makes any difference in this case, I would think that there would be no difference between writing up notes for each transaction or just one at the end of the year.

Thanks again for all the valuable input.

[JG EA]

No difference.

I think that it makes no tax difference on an individual return if the S-Corp, sole-shareholder pays/receives interest. It washes out. However, I think the danger is the IRS could say the loan is really something else. Don't forget those SUTA audits. They look very carefully at "draws".