Paid in Capital or Loan from Shareholder?

[oceanlovin'ea]

What is your opinion of the best way to handle the payments and purchases made by a shareholder/employee of a S corporation when they make the payments out of personal funds because the business is new and doesn't have enough money to pay all the bills yet?

You can increase their basis in the business by calling it paid in capital. But you could also make it a loan from the shareholder to the business. I have heard of it being done both ways and so I would just like to hear which way you think is best and why.

Thanks.

Linda F

[SunTaxMan]

Loan or basis increase

How I would treat it, and my opinion as to how I think YOU should treat it, is by asking a question of the taxpayer, "Do you INTEND this to be a loan that you want to repay to yourself, or are you making an investment in your business (that would STAY with the business for an undetermined period of time?"

Taxpayer's INTENT is the active word here. If there is uncertainty on the taxpayer's part, then discussion with you is appropriate to help the taxpayer to DECIDE how to handle it. Taxpayer should be given adequate information to make their own decision - and the business records and the tax returns, etc., be done by the Preparer to reflect the taxpayer's decision.

[Gretel]

What is also important for the shareholder's decision is if his corporation has enough equity or is rather under capitalized. Maybe it makes good sense to issue more stock if S/H can spare the money. If grossly under capitalized the corporate veil can be easily pierced in case of lawsuit.

[oceanlovin'ea]

Small business

This is a small one person s corp. She is a massage therapist. She worked with a chiropractors office for a few months and then opened her own office in May 2006. She then incorporated in August 2006.

She didn't have any capital or money that she put into the business. She had bought her equipment and furniture while sole prop, which we put into the corporation. So at this point she has very little invested in the business. She bought items she needed and paid bills out of her own personal account or on her own credit card if there was not enough money in business bank account.

I will talk to her and see if they want the business to pay them back what she has spent or if she would like it to be considered putting more money into business.

[Bees Knees]

If she were audited, the IRS might call it non-deductible personal expenses.

From TTB, page 8-13:

Paying Expenses of an Employer
If the expense paid by an employee is that of the employer and not
the employee, the expense might not be deductible. This could be
the case where a taxpayer is both the shareholder and employee
of his or her corporation. The shareholder employee may typically
pay a corporate expense, such as office rent, out of personal
funds when the corporate checkbook is low on funds. Since the
expense is a liability of the corporation and not the employee, the
expense is not deductible by the employee because it is not an
ordinary and necessary business expense under Section 162 (T.C.
Summary Opinion 2004-149). However, if the corporation has a
resolution or policy in place requiring a corporate officer as an
employee of the corporation to assume certain expenses, those
expenses would be deductible by the employee, subject to the 2%
AGI limitation on Schedule A. (T.C. Memo. 2005-197)

What she needs to do is contribute cash to the corporation and then have the corporation reimburse her for the expenses or re-pay her for the loan. You can't call it paid in capital or a loan to the corporation if the corporation never touched any of the cash. It has to first go into the corporation for it to be a corporate transaction, or the corporation has to have a written policy stating the shareholder is to pay the expense.

[oceanlovin'ea]

Bees Knees

Each of the months from August to December, she deposited the checks but kept the cash. She used that money to pay some of the bills of the corporation. How would that figure in?

I included the amounts she kept as income but not as bank deposits.

Linda

[Bees Knees]

Each of the months from August to December, she deposited the checks but kept the cash. She used that money to pay some of the bills of the corporation. How would that figure in?

I included the amounts she kept as income but not as bank deposits.

Well, you would have to argue she maintains a petty cash account. Debit petty cash and credit income. Then debit the expense and credit petty cash when an expense is paid. That should be OK, I would think, as long as it was clearly corporate cash and not her own personal funds that paid for things.

It also should not be an issue if this could all be documented in the corporate minutes.

"The corporation herby directs the shareholder to pay for expenses out of her own personal funds since the corporation is short on cash. The corporation will treat such expenses as additional paid in capital for the period XXX through XXX."

Or something to that effect.

[Golden Rocket]

Capital Contributions

During this discussion, there has been no mention of the much-feared recharacterization by the IRS - reclassifying a loan to a capital contribution. I suppose in Linda's situation, the S corp renders no advantage to the IRS since dividends wouldn't be taxable anyway.

I have a customer who converted a proprietorship to an S corp in 1999. He had $300,000 in receivables at the time of conversion. The decision was made that as of inception, he would operate entirely as a corporation and cease his proprietorship, so the $300,000 became a corporate receivable. I recommended he set up a loan payable to himself for the net assets of $325K (of which the $300K was the lions' share). I also recommended that he pay himself back and rid the corporation of this loan as soon as practical.

He didn't pay himself back, but instead lived on his salary and other personal money. Seven years later there is still $250K on the books payable to himself. It really irks me that he hasn't paid himself back. If the IRS chooses, they can reclassify the initial $325K and call it "paid-in-capital." But since this is a subchapter S, why would they bother?

A little aside in the above plot. Taxpayer lives in a state where there is no personal income tax. Most of those states (his state included), do not recognize subchapter S, so there is no target to pass through. Recharacterization would matter to those states.

Not sure there is a question here yearning for answer. But would anyone care to comment?

[Joe Btfsplk]

Generally I would cal it a loan

Unless it is going to be a more-or-less capital contribution, I would call it a loan. If it is a temporary infusion of cash it would simplify things to leave it out of the capital of the company and withdraw it as a loan repayment.

I have one client who loses money on everything he does, but makes over a million dollars a year on passive investments. He has loans on the books of one of his S Corporations for over a million dollars due to many years losses while he tried to operate it like it was a fortune 500 company. Finally he scaled back and has started making a small profit.

He has repaid some of his loans, but has a long way to go to completely repay them. In his case I've prepared his taxes the way it is shown on the books--as a loan. The IRS has not questioned it, but if they did, it might not stand up as a loan. In any case, it would not affect the profit or loss or his pass-through income on his 1040, so I see no tax assessment as a risk. There could be some risk as to his limited liability if the 'corporate veil' were pierced.

He is used to being sued and suing others, so I suppose he doesn't mind taking the risk.
When the IRS disallowed the business deduction of his Rolls Royce, he wasn't overly concerned.

[Bees Knees]

He is used to being sued and suing others...

Including you...

All the more reason to follow the rules and cover yourself when he wants to take a risky position.

[Joe Btfsplk]

Including you...

All the more reason to follow the rules and cover yourself when he wants to take a risky position.

I don't see his position as risky. It is an S Corporation. He loans the money to the corporation,. The corporation spends it for inventory and operating expenses. When funds are available in the corporation the corporation repays the loans. The only question would be an accounting classification. There have been no expenditures for personal expenses.

If the money were called Contributed Capital, he could still withdraw the cash as a shareholder distribution which would not be taxable to him or deductible by the S Corporation any more than repaying the loan.

How could he sue me over this? He would have sustained no damages and would have no basis to sue me.

You must be thinking of someone who pays personal expenses claimed as business expenses. While this could happen, it would probably be on the books as a legitimate deductible item rather than clearly identified as a fraudulent deduction.

[Golden Rocket]

There is a difference

between Loan and Capital even for a subchapter S.

An extra few thousand classified as capital rather than a loan would create a higher basis in stock. That means he can receive a distribution up to stock basis without claiming capital gains. A few thousand more in stock basis means he can receive a larger distribution.

If this were classified as a loan, it would equally accommodate the deduction of a loss but not a distribution.

[Bees Knees]

I don't see his position as risky. It is an S Corporation. He loans the money to the corporation,. The corporation spends it for inventory and operating expenses. When funds are available in the corporation the corporation repays the loans.

IF that is what really happened, fine.

However, in the context of this discussion, the original post describes the shareholder spending the money, not the corporation. Saying the shareholder loaned the money to the corporation, or contributed the money to the corporation is making something up out of thin air. If the money actually transferred from the shareholder's hands into a corporation checking account, that is one thing. Making up some transaction out of thin air after the fact so that you can take advantage of a favorable tax situation is another.

The courts have, and will continue to treat shareholder payments on behalf of the corporation as non-deductible personal expense of the shareholder, rather than a corporate expense/loan/capital if all i's are not dotted and all t's are not crossed.

And your client better be informed by you that that could happen.