Applying for an IRS ruling on your international tax planning will save you taxes in the long run.
The IRS has an easy tax win if you mess up your related party loans. When a cross-border loan is classified as not being bona-fide, the transaction is not a debt. Then, the IRS gets to determine what took place. You can expect the IRS to decide what took place will cost you the most in taxes.
On this blog, you will learn what to do and what not to make your a loan a bona fide debt.
Most of the court cases are from the first part of last century involving a closely held domestic corporation. Thus, this blog will look at those cases. You will see that in those cases, the IRS collected the most money by classifying the transaction as a taxable dividend.
The tax issue of a bona fide debt is not in the Internal Revenue Code. The courts have created a tax law that the debt must be bonafide. A law established by the courts is called a “common law.”
Many small business owners believe that if they merely record in their accounting books the transaction is a debt, then it is a debt. No so. Much more is required, and you will learn what to do and what not to do in this blog.
IRS agents are trained to examine an amount classified as a related party loan is whether there is a bona fide debt. The IRS uses this fundamental issue: When the loan was made, was there a genuine intent that the borrowed funds would be repaid?
Courts looked beyond mere labels or the parties’ testimony. The court looks at the objective facts and circumstances surrounding a transaction.
In Baird v. Commissioner, the judge ruled that “The treatment of petitioners’ (the taxpayer) withdrawals on the corporate (accounting) books as ‘Notes Receivable’ is not controlling.” “It is well settled that book entries can not be used to conceal realities as a means of relieving the taxpayer from liability for income taxes.”
Key Determining Factors
The IRS assumes that the loan in question is a dividend to the shareholder. If the transaction is between two related companies, then two taxable events occurred. First, a taxable dividend to the shareholder. Next, the money going into the other corporation is treated by as a capital contribution by the shareholder to the corporation.
When a shareholder owns the majority of a company’s stock, the IRS knows that he can exercise direct control over the business’s earnings.
Example, a shareholder controls exactly 50 percent of a corporation’s stock. The other shareholder does not object to the loan. This fact suggests that a bonafide loan was made. Since the shareholder does not own a majority of the stock, then the likelihood of a bonafide transaction is far greater.
The IRS is aware of situations where one shareholder owning only a small percentage of the stock exerted nearly total control of a corporation.  This is common in family owned businesses when dad runs the family. In these cases, the minority shareholder is treated as the majority shareholder.
Was security was given?
The failure to provide security is an indication of a non-bonafide loan. Most commercial lenders require security. Your loan needs to look like a commercial loan.
Is the shareholder in a position to repay the loan?
As I wrote above, the test is the day the loan was made. The IRS looks at a shareholder’s income and net worth in determining the shareholder’s ability to repay. You need to have this proof in your files before you make the loan. You want to act as if you are a commercial lender.
If the shareholder falls upon bad times, you want to document the change of status in corporate minutes. The IRS will try to use this event to classify the loan as not bona fide.
The shareholder who is in a position to repay the advances based on his current financial status supports a bona fide loan. An excellent credit rating is not conclusive that the shareholder is in a position to repay the loan.
If a loan is a dividend, the tax consequences are different for a S-corporation, C-corporation and a foreign company.
For a C-corporation, where the company does have current or accumulated earnings and profits (E& P) at the time of distribution (including a loan that is later classified as a distribution because it is not bonafide), the distribution is dividend.
For an S-corporation, the classification by the IRS of a loan as a distribution can:
1. terminate the S-election if the loans are made disproportionate of the ownership.
2. disallow losses to be reported on the shareholder’s income tax return because of lack of tax basis.
Was a promissory note given to the corporation by the shareholder at the time of the loan?
The fact that a promissory note of indebtedness wasn’t issued to the corporation is one of the determinative factors. However, in a few court cases where no notes were issued for advances, the advances were accepted as bona fide loans because of other factors.
Is there a repayment schedule or an attempt to repay?
Despite repayments being made, if the “loan” continues to increase over the years, the courts tend to see the transaction as a not a bona fide debt.
When the regular repayment schedule is followed the transaction looks more like a loan and not a dividend.
Is there a set due date in the written loan document.
A loan payoff time is important. Your bank would not make a loan with a due date. You want your related party loans to be like a commercial loan.
The due date must be decided at the time of the advance. With the absence of a fixed due date, the advances can still be classified as a loan if it is repaid within a reasonable period.
Was interest was charged? This a factor that by itself is not determinative.Whether the corporation has made attempts to get repaid.
If the shareholder borrower falls upon hard times and is not repaying a loan, the IRS will see this proof that the loan was not bonafide.
To counter the IRS position, the corporation must take steps to collect the loan. If the company does not apply pressure on a borrowing shareholder for repayment, the court may not see the bonafide loan transaction.
You will want to document the steps taken to get repaid in the corporate minutes and letters (or emails) to the shareholder.
The size of the advances. A corporation making big advances to a controlling shareholder looks like a distribution. Proving that the shareholder has the ability (when the loan was made) is important.
Also, if the shareholder’s ability to repay is contingent on future events, the transaction looks more like a dividend.
A corporation with a history not paying dividends has high IRS risk.
Money advanced to a shareholder of a C-corporation with substantial earnings and profits and with no history of paying dividends must be extremely careful. A foreign corporation has the same issue.
So, while the IRS strongly emphasizes to its agents that the above-listed factors are viewed as a whole, and any one factor by itself is not determinative, the IRS will be suspicious.
In Summary: Following the same procedures as a commercial lender may make your transaction bona fide.
 25 T. C. 387, 395 (1955)
 Baird v. Commissioner, 25 T. C. 387, 395 (1955)
 Smith v. Commissioner, T. C. M. 1980-15
 IRC section 301. See IRC section 316 (Dividend Defined).
 United States v. Title Guarantee & Trust Co., 133 F. 2d 990 (6th Cir. 1943).