If a shareholder's loan to a corporation becomes worthless, the debt must be considered bona fide to qualify for a bad-debt deduction [Reg. 1.166-1(c)]. To be considered a bona fide debt, the loan must meet demanding standards, especially when the shareholder is considered a related party.
Factors that the courts consider in determining whether a bona fide debt exists as a result of a transfer between related parties include:
1. The presence or absence of documentary evidence of the transaction (such as an executed note);
2. Whether there is a fixed schedule for repayment (including a maturity date);
3. Whether interest is being charged on the outstanding debt;
4. Whether collateral is obtained or requested;
5. Whether demand for repayment is made;
6. Whether any repayments have been made;
7. Whether the transaction is reflected as debt in the records of the parties; and
8. The financial condition of the debtor at the time of the loan (so that the lender can show the expectation of repayment and intent to create a valid debtor-creditor relationship).
A recent Tax Court decision (Ramig, CA-9) dated October 29, 2012 held that a corporate shareholder was not entitled to bad-debt deductions for amounts he advanced to, and paid on behalf of, the corporation because they represented equity investments, rather than loans. The corporation could not obtain loans from outside lenders, and it was not likely it could have repaid the advances from its own earnings. Although a Key Employee Agreement authorized the employee to pay expenses on behalf of the corporation, credit card charges incurred by the employee were deemed to be equity investments because the parties did not provide for interest or a repayment date, and there was no evidence the corporation had repaid similar charges in the past.
To preserve a bad-debt deduction, and support the fact that a true debt exists, shareholder loans to a corporation should always be represented by a formal note. The note should bear a fair rate of interest and should be authorized in the corporate minutes.
If you would like to discuss the proper method of documenting a shareholder loan, or would like to discuss the tax implications associated with a worthless shareholder loan, do not hesitate to contact Schneider Downs & Co., Inc. at 412-261-3644 to speak with a professional in the tax advisory services group.
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