Reading court cases often reveals how taxpayers can best structure their business transactions. In the Tax Court case of Scott Singer Installations (T.C. Memo. 2016-161), the Court discussed the criteria used to determine whether Mr. Singer was an employee and if personal expenses paid by his S corporation on behalf of Mr. Singer should be treated as wages. Mr. Singer was the sole shareholder and president of his company and served as its sole corporate officer.
To grow his business, Mr. Singer established a home equity line of credit and advanced the entire HELOC to his business. He then refinanced his primary mortgage and advanced those funds to his corporation. He later took a general business LOC and advanced those funds to his company, and borrowed from his mother and her boyfriend. Mr. Singer treated every advance he made to his company as a loan on his general ledger and IRS tax returns. He failed to execute any promissory notes, charged no interest on these advances, and did not stipulate a maturity date. When his business operated at substantial losses beginning in 2008 and could not borrow from commercial lenders, he borrowed again from his mother and her boyfriend. Mr. Singer used corporate funds to pay his personal expenses. He did not pay himself a salary. The IRS found that he was an employee and the payment of his personal expenses constituted wages subject to unpaid employment taxes.
Mr. Singer did not take exception to the IRS’s finding that he was an employee of his company subject to wage withholding. However, Mr. Singer argued that the payment by his company of his personal expenses should not be treated as wages, but as repayment of loans he made to his company. The courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include: (1) the names given to the documents that would be evidence of the purported loans; (2) the presence or absence of a fixed maturity date; (3) the likely source of repayment; (4) the right to enforce payments; (5) participation in management as a result of the advances; (6) subordination of the purported loans to the loans of the corporation’s creditors; (7) the intent of the parties; (8) identity of interest between creditor and stockholder; (9) the ability of the corporation to obtain financing from outside sources; (10) thinness of capital structure in relation to debt; (11) use to which the funds were put; (12) the failure of the corporation to repay; and (13) the risk involved in making the transfers.
The above factors serve as aids in determining whether transfers of funds to closely held corporations should be regarded as capital contributions or as bona fide loans, and no single factor is controlling. The court felt that the ultimate question is whether there was a genuine intention to create a debt, whether a reasonable expectation of repayment existed, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. The court stated that transfers to closely held corporations by controlling shareholders are subject to heightened scrutiny, and the labels attached to such transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless these labels are supported by other objective evidence.
The court focused on looking at the relative financial status of petitioner at the time the advances were made; the financial status of petitioner at the time the advances were repaid; the relationship between Mr. Singer and his company; the method by which the advances were repaid; the consistency with which the advances were repaid; and the way the advances were accounted for on the company’s financial statements and tax returns. After looking at all these criteria in the light of the other factors traditionally distinguishing debt from equity, particularly the intent factor, the court believed Mr. Singer intended his advances to be loans and found that his intention was reasonable for a substantial portion of the advances. Consequently, the court found that the company’s repayments of those loans were valid as such and should not be characterized as wages subject to employment taxes.
The court next looked at whether Mr. Singer had a reasonable expectation of repayment. Since he had a viable business for the years 2006 through 2008, the court found that there was a reasonable expectation of repayment for the loans made in those years. However when his business began to generate losses in subsequent years and he was unable to borrow from commercial lenders, the court found there was no reasonable expectation of repayment for post-2008 advances and thus those monies could not be treated as loans. The court found that the post-2008 advances were contributions of capital.
Officer/employees of S Corporations are required to pay themselves a reasonable salary. If the S Corporation’s corporate tax return had shown officer compensation and if interest expense had been paid to him by the corporation and reflected on the corporate tax return, perhaps he would not have been selected for an IRS audit exam.
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