There can be negative tax consequences when purported loan payments are recast as corporate distributions to shareholders. In some cases, the courts have ruled that withdrawals from two closely held corporations were constructive corporate distributions rather than loan proceeds and repayments. As such, the withdrawals triggered taxable dividends and capital gains for the shareholders.
Shareholder Loans: Courts Examine Eight Factors
In determining if a payment to a shareholder is proceeds from a tax-free loan from a corporation to a shareholder or a tax-free repayment of a loan from the shareholder to the corporation (as opposed to a potentially taxable corporate distribution to the shareholder), courts look at whether:
1. There is a written promise to repay evidenced by a note or other document.
2. There is a stated principal repayment schedule or balloon repayment date.
3. Principal payments are actually made on time.
4. Stated interest is charged.
5. Interest is actually paid on time.
6. There is adequate security for the purported loan.
7. The borrower has a reasonable prospect of being able to repay the loan.
8. The parties conduct themselves as if the transaction is a loan (for example, by shareholders showing loans they purportedly owe to their corporations as liabilities on personal balance sheets).
Corporate Distribution Basics
For federal income tax purposes, non-liquidating distributions paid by C corporations to individual shareholders can potentially fall into three different layers. Withdrawals from each layer have different tax consequences.
First Layer: Taxable Dividends to Extent of Earnings and Profits. Corporate distributions of cash or property are classified as taxable dividends to the extent of the corporation's current or accumulated earnings and profits, which is a tax accounting concept that is somewhat similar to the financial accounting concept of retained earnings.
Dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation distributes earnings and profits to shareholders without formally declaring a dividend but without the expectation of repayment.
The maximum federal income tax rate on C corporation dividends is 20 percent for single people with taxable income above $400,000 ($450,000 for married joint-filing couples). Upper-income individuals may also owe the 3.8 percent Medicare net investment income tax on dividend income. For other taxpayers, the tax rate on dividends remains 15 percent.
Second Layer: Tax-Free Return of Capital to Extent of Stock Basis. After the distributing corporation's E&P is exhausted, subsequent distributions reduce each shareholder's basis in his or her stock. In other words, distributions up to basis are treated as tax-free returns of shareholder capital.
Third Layer: Capital Gain after Stock Basis Is Exhausted. After a shareholder's stock basis is reduced to zero, any additional distributions are treated as capital gains. Assuming the gains are long-term because the stock has been held for more than a year, the maximum individual federal income tax rate is 20 percent for high income taxpayers.
This applies to singles with taxable income above $400,000, (married joint-filing couples with income above $450,000). For taxpayers with income below that, the maximum long-term capital gains rate is 15 percent.
Steer Clear of Negative Tax Consequences
Whenever cash or property passes between closely held corporations and their shareholders, there are tax consequences. The only way to control the tax consequences is to document what the transactions are intended to be and follow through by acting accordingly.
When transactions are intended to be loans, the objective factors in the right-hand box must be considered and respected. Otherwise, the IRS can re-characterize the transactions in ways that have negative tax consequences for shareholders, their corporations, or both. Consult with your tax adviser for guidance in your situation.