Is it Debt or Equity? Is it a Dividend or Compensation? It Must be a Closely Held Business
April 09, 2018
I had a call a couple of weeks ago from the owner of a business. His brother, who owned half of the business, owed some money to someone in connection with a venture that was unrelated to the business. The brother didn’t have the wherewithal to satisfy the debt and, to make matters worse, the person to whom the money was owed was a long-time customer of the business. The customer qua creditor had proposed and, under the circumstances, the brothers had agreed, that the business would satisfy the debt by significantly discounting its services to the customer over a period of time. The brothers wanted to know how they should paper this arrangement and that the resulting tax consequences would be.
We talked about bona fide loans, constructive distributions, disguised compensation, and indirect gifts. “What?” the one brother asked incredulously, “how can all that be implicated by this simple arrangement?” After I explained, he thanked me. “We’ll get back to you,” he said.
Last week, I came across this Tax Court decision.
A Bad Deal
Taxpayer and Spouse owned Corp 1, an S corporation. Taxpayer also owned Corp 2, a C corporation.
Things were going well for a while. Then Taxpayer bid and won a contract for a project overseas. Taxpayer formed LLC to engage in this project, and was its sole member. Unfortunately, the project required a bank guaranty. Taxpayer was unable to obtain such a guaranty, but he was able to obtain a line of credit, which required cash collateralization that he was only able to provide by causing each of his business entities to take out a series of small loans from other lenders.
The project did not go well, and was eventually shut down, leaving LLC with a lot of outstanding liabilities and not much money with which to pay them.
In order to avoid a default on the loans, Taxpayer tapped the assets of the other companies that he controlled. However, because Corp 1, Corp 2, and LLC were “related” to one another, he “didn’t see the merit” in creating any formal notes or other documentation when he began moving money among them.
Taxpayer caused Corp 2 to pay some of Corp 1’s and LLC’s debts. On its ledgers, Corp 2 listed these amounts as being owed to it, but on its tax returns, Corp 2 claimed them as costs of goods sold (COGS); because Corp 2 was profitable, there was enough income to make these claimed COGS valuable. That same year, Corp 2 issued Taxpayer a W-2 that was subsequently amended to reflect a much smaller amount.
In the following year, Corp 2 paid Taxpayer a large sum, which he used to pay a portion of LLC’s debts. Corp 2’s ledgers characterized these payments as “distributions”. Corp 2 also directly paid a significant portion of Corp 1’s and LLC’s expenses, which its ledger simply described as “[Affiliate] Payments.”
That same year, Corp 2 elected to be treated as an S corporation and filed its tax return accordingly, reporting substantial gross receipts and ordinary business income, which flowed through to Taxpayer. At the same time, Taxpayer and Spouse claimed a large flow-through loss from Corp 1 – a loss that was principally derived from Corp 1’s claimed deduction for “Loss on LLC Expenses Paid” and its claimed deduction for “Loss on LLC Bad Debt.” Taxpayer’s W-2 from Corp 2, however, reported a relatively small amount in wages.
The IRS Disagrees
The IRS issued notices of deficiency to: (i) Corp 2 for income taxes for the first year at issue (its last year as a C corporation), (ii) Taxpayer for income taxes for both years at issue, and (iii) Corp 2 for employment taxes for the second year at issue in respect of the amounts it “distributed” to Taxpayer and the amounts it used to pay Corp 1’s and LLC’s expenses. Taxpayer petitioned the Tax Court.
The Court considered whether:
- Corp 2’s payment to creditors of Corp 1 and LLC were a loan between Corp 2 and those companies, or a capital contribution that was also a constructive dividend to Taxpayer;
- Corp 1 was entitled to a bad-debt deduction for payments it made to LLC’s creditors prior to the years at issue, or for the payments Corp 2 made; and
- Corp 2’s payments to Taxpayer and to creditors of Corp 1 and LLC should be taxed as wages to Taxpayer and, thus, also subject to employment taxes.
Loans or Constructive Dividends?
Corp 2 claimed a COGS adjustment for expenses of Corp 1 and LLC that it had paid. However, it changed its position before the Court, arguing that the payment was a loan.
The IRS countered that the payment was only “disguised” as a loan; it was not a bona fide debt. Rather, it was really a contribution of capital by Corp 2 to each of Corp 1 and LLC. According to the IRS, this made the payment a constructive dividend to Taxpayer, for which Corp 2 could not claim a deduction, thereby increasing its income.
A bona fide debt, the Court explained, “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”
Whether a transfer creates a bona fide debt or, instead, makes an equity investment is a question of fact. To answer this question, the Court stated, one must ascertain whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”
According to the Court, there are a number of factors to consider in the “debt vs equity” analysis, including the following:
- names given to the certificates evidencing the indebtedness
- presence or absence of a fixed maturity date
- source of payments
- right to enforce payments
- participation in management as a result of the advances
- status of the advances in relation to regular corporate creditors
- intent of the parties
- identity of interest between creditor and stockholder
- “thinness” of capital structure in relation to debt
- ability to obtain credit from outside sources
- use to which the advances were put
- failure of the debtor to repay
- risk involved in making the advances.
Corp 2’s book entries showed a write-off for payments made to Corp 1 described as “Due from Related Parties” which made it seem as though Corp 2 intended the payments to be loans. But Corp 2 deducted the payments as “purchases,” thus belying the label used on its books. And when Corp 2 made the payments, it didn’t execute a note, set an interest rate, ask for security, or set a maturity date.
The lack of these basic indicia of debt and Corp 2’s inconsistent labeling weighed in favor of finding that Corp 2 intended the payments to be capital contributions, not loans.
The fact that Corp 1 and LLC were broke when Corp 2 made the payments also undermined Taxpayer’s position that the payments were loans. Taxpayer testified that LLC “had no funds” or “wasn’t capitalized,” and its only contract (for which it hadn’t been paid) had been canceled. Corp 1’s situation was similar; it had virtually no book of business, its liabilities exceeded its assets, and it was losing money.
So, Corp 2’s payments went to entities that were undercapitalized, had no earnings, and could not have obtained loans from outside lenders – all factors suggesting that the payments were capital contributions.
The Court observed that Taxpayer treated legally separate entities as one big wallet. “Taking money from one corporation and routing it to another will almost always trigger bad tax consequences unless done thoughtfully.” The Court stated that “Taxpayer did not approach LLC’s problems with any indication that he thought through these consequences or sought the advice of someone who could help him do so.”
The Court found that Corp 2’s payments were not loans to LLC and Corp 1, but were capital contributions; the entities didn’t intend to form a debtor-creditor relationship.
The Court then considered whether Corp 2’s payments were constructive dividends to Taxpayer. A constructive dividend, the Court explained, occurs when “a corporation confers an economic benefit on a shareholder without the expectation of repayment.”
A transfer between related corporations, the Court continued, can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds. That type of transfer is a constructive dividend if the common shareholder has direct or indirect control over the transferred property, and the transfer wasn’t made for a legitimate business purpose but, instead, primarily benefited the shareholder.
Taxpayer had complete control over the transferred funds – he was the sole shareholder of Corp 2, the sole member of LLC, and he owned 49% of Corp 1. Moreover, there was no discernible business reason for Corp 2 to make the transfers because there was no hope of repayment or contemplation of interest. The transfer was bad for Corp 2, but it was good for Taxpayer because it reduced his other entities’ liabilities.
Corp 2’s payment of LLC’s and Corp 1’s expenses, therefore, was a constructive dividend to Taxpayer.
On their tax return, Taxpayer and Spouse claimed a large flow-through loss derived from a bad-debt deduction that Corp 1 took for earlier payments it made on behalf of LLC, and a deduction that it took for “Loss on LLC Expenses Paid.” The IRS denied all of these deductions, increasing the Taxpayer’s flow-through income from Corp 1.
Before there can be a bad-debt deduction, there had to be a bona fide debt. Even when there was such a debt, the Court continued, a bad-debt deduction was available only for the year that the debt became worthless.
The Court recognized that “transactions between closely held corporations and their shareholders are often conducted in an informal manner.” However, given the significant amount of the purported debt, the Court noted that the absence of the standard indicia of debt – formal loan documentation, set maturity date, and interest payments – weighed against a finding of debt.
The only documents Taxpayer produced about the purported loans were its books.
The amount that Corp 2 paid and that Corp 1 deducted that same year as “Loss on LLC’s Expenses Paid” appeared as entries on those books. But, the Court stated, it is not enough to look at the label a corporation sticks on a transaction; one has to look for proof of its substance, which the Court found was lacking.
Based upon the “debt vs equity” factors described above, the absence of any formal signs that a debt existed, and the underlying economics of the situation, the Court found that Taxpayer was “once again just using one of his companies’ funds to pay another of the companies’ debts.” Therefore, Corp 1’s advances to LLC did not create bona fide debt for which a bad debt deduction could be claimed.
Taxpayer argued that the payments he received from Corp 2, and that he immediately used to pay other corporate debts, was either a distribution or a loan. He also claimed that Corp 2’s payments to Corp 1’s and LLC creditors were loans.
The IRS contended that these payments were wages to Taxpayer, and argued that Corp 2 “just called them something else” to avoid employment taxes.
The Court pointed out that these payments lacked formal loan documentation, had no set interest rate or maturity date, were made to companies with no capital, and could be repaid only if the companies generated earnings. For those reasons, the payments couldn’t have been loans.
But were the payments wages, as the IRS insisted?
Wages are payments for services performed. Whether payments to an employee-shareholder are wages paid for services performed or something else – such as dividends – is a question of fact. Again, the Court emphasized that all the evidence had to be considered; one had to look to the substance of the situation, not the name the parties gave a payment.
According to the Court, a significant part of this analysis was determining what “reasonable compensation” for the employee’s services would be. Among the factors to consider in making this determination were the following:
- employee’s qualifications
- nature, extent and scope of the employee’s work
- size and complexities of the business
- comparison of salaries paid with the gross income and the net income
- prevailing general economic conditions
- comparison of salaries with distributions to stockholders
- prevailing rates of compensation for comparable positions in comparable concerns
- salary policy of the employer as to all employees
- in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.
The IRS estimated the salary for the CEO of a company comparable to Corp 2, and pointed out that while Taxpayer’s W-2 fell short of this salary, the amount paid to Taxpayer came fairly close to the IRS’s estimate when combined with the contested payments. There was no reason, the Court stated, “for us to think that the IRS’s estimate was unreasonable given Taxpayer’s decades” of business experience and the fact that he singlehandedly ran three companies, one of which was very profitable.
The overlapping, but not necessarily identical, ownership of closely held business entities, especially those that are controlled by the members of a single family, can breed all sorts of tax issues for the entities and for their owners.
Intercompany transactions, whether in the ordinary course of business or otherwise, have to be examined to ensure that they are being undertaken for valid business reasons. That is not to say that there cannot be other motivating factors, but it is imperative that the parties treat with one another as closely as possible on an arm’s-length basis.
To paraphrase the Court, above, related companies and their owners may avoid the sometimes surprising and bad tax consequences of dealing with one another – including the IRS’s re-characterization of their transactions – if they act thoughtfully, think through the tax consequences, and seek the advice of someone who can help them.