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Ask Toolkit About Loans vs. Dividends

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By | May 20, 2012

Dear Toolkit,

I recently read a real horror story! A man lent his new company $125,000 and when it paid most of it back to him a few years later, the payment was taxed as dividend income. The poor guy ended up paying the IRS more than $30,000 in taxes on the $117,000 loan repayment he received. How is this possible?

Thanks,

Irate in Indiana

Dear Irate in Indiana,

So now you've learned that Stephen King didn't write all the scary tales in the world! In fact, as prolific and horrific an author as King is, he'll never catch up to the IRS in either number of victims or level of frightfulness.

In the case you cite, the mystery is wrapped in this proverbial riddle: When is a loan repayment not a loan repayment? When it's a dividend, of course!

Your case is a classic example in a steady stream of such incidents throughout the bloody history of small business taxation. It's a very common, very costly—but very avoidable—tax trap. The leading character is one Norton M. Bowman, the ill-starred president, chief executive officer, and sole shareholder of Norton M. Bowman and Associates, Inc. Our victim/hero formed his company in Richmond, Virginia, in the late 1970s and engaged in the business of constructing single-family homes.

Soon after the business was formed, a local bank granted it a $150,000 line of credit to fund its operations. The line was secured by certificates of deposit owned personally by Mr. Bowman. Due to double-digit interest rates that developed in the early 1980s, the home building business wasn't exactly booming, and in 1981 the bank called in its line of credit. The CDs were cashed in to pay the outstanding balance owed on the line and Bowman's attorney prepared a non-interest-bearing, payable-on-demand note from the corporation to its owner for the amount of the payoff—roughly $125,000.

Due to the slow housing market from 1981 to 1985, the company was mostly inactive while our hero busied himself with a travel agency he also owned. At no time did Bowman ever take salary or dividends from the home construction company. And we should mention that during this time the "note" was among the items lost in a flood. Life went on uneventfully until 1988 when the corporation distributed to Bowman $117,000 from proceeds it derived from the closing of one of the houses it developed. Business was picking up and the company no longer needed the money.

The company had reported an increase in debts due to officers of $123,000 on its 1981 tax return and on its 1988 return it reported a $125,000 decrease in the same account, of which the $117,000 distribution was a part. The story the tax returns told was that Bowman was getting back most of the money he loaned his company years before.

The IRS read that story and didn't like the ending, so they rewrote it. They said Bowman owed them a chunk of tax on dividend income he received from his company. And the Tax Court agreed with the IRS. They said that even if the "note" hadn't been lost in the flood, it wouldn't have changed the character of (what the government viewed as) the equity capital Bowman put into the business into the loan that Bowman claimed it was. And the court quoted language as colorful and fanciful as any mystery writer's: to wit, the law requires "a declaration of intention to create an indebtedness and more than the existence of corporate paper encrusted with the appropriate nomenclatural captions."

The judge seemed to feel that no unrelated third party would have loaned money to the company in its 1981 condition and that the infusion of capital by Bowman at that time was just that—capital, not debt. Further, a non-interest-bearing note with no fixed repayment date is a non-loan in Uncle Sam's book, however it may be "encrusted." And since he wanted to live happily ever after, Bowman had to pay the $30,000 income tax tab.

Now the moral of this story is that whenever you lend money to (or for that matter borrow it from) your company, it is essential for you to document that loan as rigorously as any bank would. The note must state a market rate of interest, a finite due date, and the interest must actually be timely paid. Minute book entries and all the nitty-gritty legalities must be observed if you are to have any chance of avoiding a "recharacterization" of your loan into taxable income.

Even if you don't operate as a corporation, it's smart business to detail and document all such transactions thoroughly to distinguish them from what the IRS may view as taxable. Partnerships and LLCs and even proprietorships can write happy endings to their IRS stories by simply following good business procedures for documenting the flow of funds.

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