Loans Between Related Entities
January 16, 2017
What Was Intended?
Over the last thirty years, I have reviewed the income tax returns of many closely held corporations and partnerships. Quite often, on Schedule L (the balance sheet), I will see an entry for “other assets” or “other liabilities,” which are described on the attached explanatory statement as loans to or from affiliates, as the case may be. I then ask a series of questions: did the board of directors or managers of the entities approve the loan; how was the loan documented; is there a note with repayment terms; is the debt secured; does the loan provide for interest; has interest or principal been paid; has there ever been a default and, if so, has the lender taken action to collect on the loan?
The proper characterization of a transfer of funds to a business entity from a related entity may determine a number of tax consequences arising from the transfer, including, for example, the following: the imputation of interest income to the lender; the ability of the lender to claim a bad debt deduction; the payment of a constructive dividend to the lender’s owner where the “loan” is really a capital contribution.
If a transfer of funds to a closely held business is intended to be treated as a loan, there are a number of factors that are indicative of bona fide debt of which both the purported lender and the borrower should be aware: evidence of indebtedness (such as a promissory note); adequate security for the indebtedness; a repayment schedule, a fixed repayment date, or a provision for demanding repayment; business records (including tax returns) reflecting the transaction as a loan; actual payments in accordance with the terms of the loan; adequate interest charges; and enforcement of the loan terms.
The big question is 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?” A transaction will come under special scrutiny where the borrowing entity is related to the lender. In that case, especially, can it be shown that there was a realistic expectation of repayment? Would a third party lender have made the loan on similar terms?
A recent Tax Court opinion considered these questions at some length.
An “Investment Company”?
Taxpayer was the sole owner of Corp, an S corporation that advanced funds to start-up companies and to established companies that had an opportunity for a new product or line of business. Inexplicably, Taxpayer rarely reviewed formal written projections. obtained any third-party audits, or requested any financial statements for the companies that Corp invested in. As a matter of course, Corp did not finance any company if that company had other means to borrow, such as traditional banking. Taxpayer acknowledged that Corp provided “high-risk capital” and that it was engaged in “an investment business.”
In “return” for the money that Corp advanced, Taxpayer would acquire an equity interest in the borrower-company. Taxpayer would also acquire financial control over of the company by becoming a director, a bank account signatory, and the CFO.
According to Taxpayer, repayment of amounts advanced by Corp to a company to fund a start-up or other new “project” were not anticipated until the project had been “completed.”
Corp invested in three Companies that were relevant to the tax year at issue. Corp advanced significant amounts to each Company, some of which were advanced after the year at issue. In each case, Taxpayer acquired a significant equity interest in the Company; he was appointed a director, the CFO, the bookkeeper, and the paymaster of the Company; and he was made a signatory of its accounts. Taxpayer never received a salary from the Companies, and he stipulated that his goal for his investment in the Companies was to profit from his ownership interest.
Although Corp’s records included journal entries labeling some of its advances to the Companies as “loans,” neither Taxpayer nor Corp executed any notes, agreements, or other documents evidencing any loans to the Companies.
The IRS Steps In
On its tax return, on Form 1120S, for the tax year at issue, Corp deducted approximately $10 million as bad debt that was attributed to the advances made to the Companies. According to Taxpayer, he believed the possibility that the Companies would become profitable was remote. The bad debt deduction resulted in Corp’s reporting a net loss for the year; this loss flowed through to the Taxpayer’s personal income tax return.
The IRS examined Corp’s tax return for the tax year at issue and concluded that the bad debt deduction was erroneous. The IRS issued a notice of deficiency that disallowed Corp’s bad debt deduction, attributed the resulting income to the Taxpayer, and determined the resulting deficiency in tax.
The Tax Court asked Taxpayer to offer into evidence financial information regarding the Companies to show that they could not pay the debts to Corp. Taxpayer was unable to do so. Taxpayer did not provide any evidence that Corp ever held any of the Companies in default, and he admitted that Corp neither demanded repayment of these advances from the Companies, nor did it take legal action against them. There was no documentary evidence that Corp wrote off any portion of the alleged debts of the Companies on its books for the tax year at issue. Indeed, after the year at issue, the Companies were still operating and in good standing.
Taxpayer asserted that because he was an insider wearing several hats, no formal demands were necessary. He also claimed that Corp did not take legal action against the Companies because of his status as a shareholder of the Companies.
Bona Fide Debt
A taxpayer is entitled to a deduction in a tax year for any bona fide debt that becomes worthless within the tax year.
To be able to deduct the reported bad debt for the tax year at issue, Taxpayer had to show: (1) that the advances made to the Companies were debt (not equity); (2) that the debt became worthless in the year at issue; and (3) that the debt was incurred not as an investment, but in connection with a trade or business (i.e., the business of promoting, organizing, and financing or selling corporations). (If a taxpayer makes advances as an investor, and not in the course of a trade or business, then its loans may yield nonbusiness bad debt, which may be deducted as such only when they become worthless, and then only as short-term capital losses.)
According to the Court, a bona fide debt arises from “a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money.” By definition, a capital contribution is not a debt. The question before the Court was whether Taxpayer proved that Corp’s advances to the Companies were loans or, instead, were equity investments.
The Code authorizes the IRS to prescribe regulations setting forth factors to be taken into account in resolving the issue of whether an interest in a corporation is debt or equity, and it provides five factors that “the regulations may include”, the first of which is “a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest.” The other factors are: whether there is subordination to or preference over any indebtedness of the corporation; the ratio of debt to equity of the corporation; whether there is convertibility into the stock of the corporation; and the relationship between holdings of stock in the corporation and holdings of the interest in question.
Many courts have expanded upon these factors, and have relied upon the following criteria by which to judge the true nature of an investment which is in form a debt:
(1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the “thinness” of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.
However, the courts have also cautioned that, in such an analysis, no single criterion or group of criteria is conclusive. Moreover, the enumerated factors should be used only as aids in analyzing the economic reality of the transaction; that is, whether there is actually a contribution to capital or a true loan for income tax purposes.
The Court’s Analysis
The Court grouped the above factors into three categories: (1) the intent of the parties; (2) the form of the instrument; and (3) the objective economic reality of the transaction as it relates to the risks taken by investors.
The Court noted that, unlike most “debt vs. equity” controversies, which involve investments in the form of a debt, Corp’s investment in the Companies had little or no form. There was no loan agreement providing for repayment of Corp’s advances; there was no written agreement of any sort.
According to the Court, the absence of an unconditional right to demand payment was practically conclusive that an advance was an equity investment rather than a loan for which an advancing taxpayer might be entitled to claim a deduction for a bad debt loss.
The salient fact of this case, the Court continued, was the lack of written evidence demonstrating that there was a valid and enforceable obligation to repay on the part of any of the Companies at issue that received advances from Corp. There was no written evidence of an enforceable obligation between Corp and any of the Companies, much less a provision for a fixed maturity date or a fixed rate of interest.
The Court observed that Taxpayer was not a financially unsophisticated person unaccustomed to having written agreements, yet the loans allegedly made by Corp were undocumented. Taxpayer’s uncorroborated oral testimony was insufficient to satisfy his burden in an equity-versus-debt determination. The absence of any type of formality typically associated with loans supported the conclusion that the advances were contributions to capital.
Taxpayer testified that the intent of both sides was that this was a loan and that there would be no profit-sharing, that interest would be paid and only interest would be paid, and that principal and only principal would be repaid. There was, Taxpayer said, an understanding between the parties that the borrower would post the advances as borrowed money and the lender would post them as money loaned out; and consistent with that, Taxpayer offered Corp’s journal entries that labeled some advances as loans.
In the absence of direct evidence of intent, the Court stated, the nature of the transaction may be inferred from its objective characteristics. In this case, the Court continued, no loans were documented. Such objective characteristics may include the presence of “debt instruments, collateral, interest provisions, repayment schedules or deadlines, book entries recording loan balances or interest payments, actual repayments, and any other attributes indicative of an enforceable obligation to repay the sums advanced.”
The Court then turned to the economic reality of the advances. “A court may ascertain the true nature of an asserted loan transaction by measuring the transaction against the ‘economic reality of the marketplace’ to determine whether a third-party lender would extend credit under similar circumstances.”
If an outside lender would not have loaned funds to a corporation on the same terms as did an insider, an inference arises that the advance is not a bona fide loan; in other words, would an unrelated outside party have advanced funds under like circumstances?
Taxpayer stated that the Companies he chose to finance were start-up ventures that could not obtain financing from unrelated banks. As a matter of Corp policy, if a start-up company had other sources or means to borrow, Corp would not advance money to it. The Court concluded that the Companies were objectively risky debtors, and an unrelated prospective lender would probably have concluded that they would likely be unable to repay any proposed loan.
When Taxpayer decided to write off the advance to the Companies, it was because he believed the possibility they would be profitable was remote. And yet Corp continued to provide financing to the Companies after the tax year for which the bad debt deduction was claimed. No prudent lender would have continued to advance money to any of the Companies under such circumstances. The amounts advanced to the Companies were, as a matter of economic reality, placed at the risk of the businesses and more closely resembled venture capital than loans.
Also at odds with a conclusion that this was a genuine loan transaction was Taxpayer’s failure to obtain third-party audits, financial statements, or credit reports for the Companies that Corp had chosen to invest in.
The Court believed that no reasonable third-party lender would have extended money to these Companies when none of the objective attributes which denote a bona fide loan were present, including a written promise of repayment, a repayment schedule, and security for the loan.
The transfers simply did not give rise to a reasonable expectation or enforceable obligation of repayment. For these reasons, the Court found that the relationship between Taxpayer and Corp on the one hand and the three Companies on the other was not that of creditor and debtor, and the Court concluded that Corp’s advances of funds were in substance equity, and that the IRS properly disallowed the deduction.
The factors discussed by the Court, above, provide helpful guidance for structuring a loan between related companies. If these factors are considered, and the parties to the loan transaction document it on a contemporaneous basis, they will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction. Of course, they will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.
There are many other situations in which the proper characterization of a transfer of funds between related entities can have significant income tax consequences. The bottom line in each case can be stated simply: decide early on what is intended, then act accordingly