Author: LegalEase Solutions
You have asked us to research how the Internal Revenue Service treats loans made to an officer/shareholder of a company in which the loan is not supported by a promissory note, and whether the IRS deems such a transfer to be compensation, rather than as a loan receivable. You have also asked us to research what criteria are used by the courts to determine whether such a transfer can be classified as a loan rather than compensation, as well as the nature of the burden and proofs necessary for that result. These issues require discussion of:
- The Internal Revenue Code
- Applicable case law/Tax Court Memos
- The Internal Revenue Code
26 USCS § 61 sets forth the Internal Revenue Service’s definition of gross income:
(a) General definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
- (1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
- (2) Gross income derived from business;
- (3) Gains derived from dealings in property;
- (4) Interest;
- (5) Rents;
- (6) Royalties;
- (7) Dividends;
- (8) Alimony and separate maintenance payments;
- (9) Annuities;
- (10) Income from life insurance and endowment contracts;
- (11) Pensions;
- (12) Income from discharge of indebtedness;
- (13) Distributive share of partnership gross income;
- (14) Income in respect of a decedent; and
- (15) Income from an interest in an estate or trust.
Thus, loans or advancements do not constitute gross income as the term is specifically defined by the Internal Revenue Code. Likewise, a return of capital invested in a corporation by a stockholder does not constitute gross income as articulated by the Code. It is therefore necessary to examine case law to determine the standard used to classify a transfer of funds from a company to an officer/shareholder as either a loan or as compensation, which in turn dictates whether the amount must be included in the taxpayer’s gross income.
Applicable Case Law
While many cases have interpreted § 61(a) of the Internal Revenue Code, supra, to mean that Congress intended to tax all instances of gain regardless of their form (see Marsh v. Commissioner 73 T.C. 317, 327-328 (1979)), the court in Dean v. Commissioner 35 T.C. 1083 (1961) specifically held that interest-free loans, for example, result in no interest deduction for the borrower, no interest income to the lender, and (most importantly) no taxable gain to the borrower. Loan proceeds are not considered to be gross income. In order to fall under the protection of the Dean holding, however, the transfer must in reality be a loan, rather than payment of disguised compensation.
Various cases have addressed the distinctions between true loans and disguised compensation, and have set forth criteria by which such transfers will be categorized. First, the case of Rogers v. Commissioner T.C. Memo 1993-444 (1993) conclusively held that the officer/shareholder bears the burden of demonstrating that amounts received from the corporation are indeed loan proceeds, rather than taxable compensation for services provided. The court outlined certain conditions beneficial for the taxpayer to demonstrate in order for the funds to be treated as a loan, including (1) the existence of corporate records indicating that the corporation itself considered the transfer to be a loan; (2) tax returns filed by the corporation indicating amounts due on loans to shareholders.
Evaluation of whether a transfer from a corporation to an officer/shareholder is a debt or equity was given elaborate treatment in the case of Green Leaf Ventures v. Commissioner T.C. Memo 1995-155 (1995). The case outlines eleven factors to be used in evaluating transfers between corporations and officers/shareholders, including:
- The names given to the certificates evidencing the indebtedness;
- The presence or absence of a maturity date;
- The source of payments;
- The right to enforce payment of principal and interest;
- Participation in management;
- A status equal to or inferior to that of other regular corporate creditors;
- The intent of the parties;
- “Thin” or adequate capitalization;
- Identity of interest between creditor and stockholder;
- Payment of interest only out of “dividend” money;
- Ability to obtain loans from outside lending institutions.
Id. at 32.
The Green Leaf court further held that a valid debt may exist between related parties without the formalities or existence of a promissory note, and that the court’s determination “is governed by economic substance and reality rather than form.” Id. at 34. Further, the court in Heller v. Commissioner 1996 U.S. App. LEXIS 32880 (9th Cir. 1996) held that the determination of whether a payment is a loan or is compensation is entirely a factual matter. According to James v. U.S. 366 U.S. 213, 219; 6 L. Ed. 2d 246; 81 S. Ct. 1052 (1961), the hallmark of a loan is a consensual recognition of an obligation to repay.
The case of Frierdich v. Commissioner 925 F2d180, 182 (7th Cir. 1991) utilized several objective factors to determine the taxpayer’s intent and whether a bona fide loan occurred. The factors applied by the court included:
- The existence or non-existence of a debt instrument;
- Provisions for security, interest payments, and a fixed payment date;
- Whether or not repayments of the loan were made;
- The taxpayer’s ability to repay the loan;
- The borrower’s receipt of compensation;
- The testimony of the taxpayer.
See also Matter of Uneco, Inc. 532 F2d 1204, 1208 (8th Cir. 1976); In the Matter of Indian Lake Estates, Inc. 448 F2d 574, 578-79 (5th Cir. 1971); Haber v. Commissioner 52 T.C. 255 (1969), aff’d. 422 F2d 198 (5th Cir. 1970).
In assessing the circumstances listed above, the statements of an interested party as to his or her own intentions are not necessarily conclusive, even when they have not been contradicted. Lerch v. Commissioner T.C. Memo 1987-297 (1987); Snyder v. Commissioner 34 T.C. 400, 405-06 (1960), aff’d., 288 F2d 36 (7th Cir. 1961); and Busch v. Commissioner T.C. Memo 1983-98 (1983). Such statements will be taken together with the objective standards used to distinguish true loans from disguised compensation. Spheeris v. Commissioner 284 F2d 928, 931 (7th cir. 1960). Again, according to Rogers, supra, the taxpayer bears the burden of demonstrating conclusively that amounts received are not taxable compensation, but proceeds from a bona fide loan.
In Saunders v. Commissioner, T.C. Memo 1982-655 (1982), the Commissioner contended that amounts paid to the taxpayer’s two children pursuant to an educational benefit plan established by the taxpayer’s corporation, regardless of whether denominated as scholarship grants or “loans”, in actuality represented payment of compensation to the taxpayer himself. The taxpayer argued that amounts paid under the plan adopted by the corporation were loans to the children, and not taxable income.
The court found strong evidence to indicate that there was never any intent on the part of the children to repay the amounts received, including the extremely liberal repayment forgiveness provisions which contradict any claimed intent to execute a normal arm’s-length loan. The intention of the parties is determined not so much by what a particular transaction is called, or even what form it takes, as it does to evidence of an actual intent that any money advanced will be repaid. Saunders at 23-24, citing Berthold v. Commissioner 404 F2d 119, 122 (6th Cir. 1968).
The case of Frierdich v.Commissioner, supra, held that a transaction between the taxpayer and the principal of a corporation with which the taxpayer was involved in business dealings was not a loan, but rather an impermissible sheltering of fees owed to the taxpayer by the business entity. The court found that the terms of the promissory note which linked repayment to final settling of the estate of a deceased principal in the business indicated that the transfer was not a loan, but rather payment for services rendered. The court further cited the lack of arm’s-length bargaining between the two parties as additional evidence that the transfer was not a true loan. The taxpayer failed to carry his burden of demonstrating any intent to repay the funds, and the amounts received were therefore includable in the taxpayer’s gross income.
In conclusion, whether a transfer from a corporation to an officer/shareholder will be treated as a loan or as compensation determines if amounts received must be included in a taxpayer’s gross income. This determination is made by courts through examinations of the conditions attendant to the transaction.
A true loan will be found where there is clear evidence of intent to repay the debt obligation. Additional factors increasing the likelihood that the courts will deem a transfer to be a loan rather than compensation include the existence of a debt instrument (although a promissory note or other similar formalities are not strictly required), provisions for interest payments, evidence of the taxpayer’s ability to repay the loan, and a fixed payment date. The burden of establishing these proofs lies with the taxpayer, and his or her characterization of the transaction may not be conclusive on its own, even when not contradicted. In the absence of such demonstrations by the taxpayer, courts are likely to find that such transfers from a corporation to an officer/shareholder are merely disguised compensation, and the amounts received are includable in the taxpayer’s gross income.