A corporation’s capital structure should be designed, when possible, to allow corporate cash to be withdrawn without incurring double taxation. At first glance, it might seem that a minimal amount of stock should be issued, with the bulk of the corporation’s capital coming from shareholder loans (to make corporate distributions either deductible interest expense or tax-free principal repayments). Within reason, this is a good approach. However, the IRS is likely to challenge capital structures when the equity is “thin” in relation to the debt, particularly when that debt is attributed to controlling shareholders who hold debt and stock in the same proportions.
In addition, the corporation’s future capital needs, and its ability to service the debt in light of these needs, must be considered. There will still be a net tax cost from interest paid to the shareholders when their marginal tax rates are higher than that of the corporation. Having large shareholder debt can also adversely affect the corporation’s ability to obtain outside financing.
Maximizing Bad Debt Deduction on Shareholder’s Loan to a Corporation
Business bad debts are fully deductible in the year they become partially or entirely worthless (Secs. 166(a)). This is typically preferable to the tax treatment of nonbusiness bad debts, which are deductible as a short-term capital loss in the year the debt becomes totally worthless. A business bad debt occurs when:
- The debt generating the loss was created or acquired in the course of the taxpayer’s trade or business (e.g., as trade receivables); or
- The worthless debt is incurred in the trade or business of the taxpayer (Sec. 166(d)(2); Regs. Sec. 1.166-5(b)).
Determining a taxpayer’s trade or business is important in analyzing business versus nonbusiness debts because a business bad debt must be created in, or related to, the taxpayer’s trade or business. Case law has established that the business carried on by a corporation is not considered the business of a shareholder simply because of the corporation-shareholder relationship. However, a corporation may carry on the same business as a shareholder, or they may be involved in related businesses.
Case law has also determined that being an employee is a trade or business (Trent, 291 F.2d 669 (2d Cir. 1961)). A shareholder’s loan that is closely related to the shareholder’s trade or business as an employee will qualify as a business debt. However, a loan to a corporation will be a business debt only if the shareholder’s primary purpose in making the loan is to protect his or her employment (Generes, 405 U.S. 93 (1972); Litwin, No. 89-1072-C (D. Kan. 1991), aff’d, 983 F.2d 997 (10th Cir. 1993)).
Establishing that the employee relationship is the primary motivation for the loan is necessary because of the dual involvement the shareholder-employee has with the corporation. A loan from a shareholder-employee to a corporation may be both investment and employment related. A loan that is made primarily to protect an investment will be a nonbusiness debt, typically resulting in less preferential treatment if the loan becomes uncollectible. Thus, proving that the primary purpose of the loan is protection of the shareholder’s employment becomes significant.
The Ninth Circuit has held that a shareholder-employee’s business bad debt deduction for loans he made to his corporation as an employee was a miscellaneous itemized deduction subject to the 2% floor and not an adjustment to gross income as the employee had contended (Graves, 220 Fed. Appx. 601 (9th Cir. 2007)). The court relied on Sec. 62(a)(1), which provides that trade or business expenses do not include those connected with services as an employee. The performance of personal services as an employee does not constitute carrying on a trade or business (Temp. Regs. Sec. 1.62-1T(d)).
While being an employee is important to establish a business bad deduction under Sec. 166, the Sec. 62 definition of trade or business expenses reduces the tax benefit because the shareholder-employee can deduct business bad debts only in excess of 2% of adjusted gross income (AGI).
Practice tip: Shareholders may do better making a capital contribution to the corporation, rather than lending money, if the contribution would qualify for Sec. 1244 treatment. Then, if the stock becomes worthless, the shareholder can take an ordinary loss deduction for the stock.
The following factors indicate that employee status was the primary motive in a shareholder’s loan to a corporation (Smith, 60 T.C. 316 (1973), acq., 1972-2 C.B. 3; LaStaiti, T.C. Memo. 1980-547; Hutchinson, T.C. Memo. 1982-45; Alsobrook, 431 F. Supp. 1122 (E.D. Ark. 1977), aff’d, 566 F.2d 628 (8th Cir. 1977)) when:
- The employee’s after-tax compensation was much larger than his or her investment in the corporation;
- The shareholder-employee’s other sources of income indicated that he or she was dependent on his or her salary income;
- The time spent by the shareholder-employee in his or her role as employee was substantial; and
- The value of the shareholder’s investment when the shareholder made the loan was insignificant.
Example 1: Assume that D, Inc. (owned equally by A, B, and C) manufactures optical equipment developed by A. Each shareholder originally invests $10,000 in the corporation. During the first two years of operation, A works approximately 35 hours a week managing D, while B and C are not active in the company’s operations. A also consults part-time to R, a retail store; however, he has not received any income from R. During these years, D pays nominal dividends to the shareholders and an annual salary of $35,000 to A. A’s adjusted gross income has approximated $42,000.
D’s sales declined so it applied for a loan to cover operating expenses. The bank refused to loan money to the corporation. However, the bank loaned $46,000 to A based on the fact that he gave the bank a security interest in undeveloped land that he owned. A then loaned the $46,000 to D. At that time, the corporation’s liabilities exceeded its assets. Later that year, D shut down its operations and satisfied all its creditors except A.
Since A is not involved in banking or a separate trade or business that deals with D, the loan to D was not created in the course of A’s business. To qualify the loan as a business bad debt, A must establish that he was in the trade or business of being an employee and that there was a relationship between his employment and the loan.
A’s lack of income from other sources and his history of full-time involvement in D is evidence of A’s employment status. A’s annual salary, which substantially exceeded the value of his D stock when he made the loan, is evidence that A’s primary purpose in loaning money to D was to protect his employment.
Further, the bank’s refusal to loan money to D and its request of security interest in property other than A’s D stock support the stock’s zero value when the loan was made (Hutchinson, T.C. Memo. 1982-45). Thus, the loan is a business bad debt, and A can deduct the $46,000 loss as an employee business expense subject to the 2% of AGI floor (Graves, 220 Fed. Appx. 601 (9th Cir. 2007)).
Observation: A consulting agreement with R giving A a fee on completion of a specific project might weaken the employment argument if the IRS challenged the bad debt deduction. In that case, the debt might be a business debt of A’s consulting business if the consulting work involves equipment that D manufactures (Wade, T.C. Memo. 1963-50).
Example 2: Assume now that A paid D’s expenses rather than loaning money. A shareholder may not deduct expenses incurred on behalf of the corporation because the taxpayer is an investor in the corporation, and investing is not a trade or business.
Any return A might get from his interest in D is based on D’s trade or business, not A’s trade or business (Whipple, 373 U.S. 193 (1963); Dietrick, 881 F.2d 336 (6th Cir. 1989)). Generally, the expenses would be treated as capital contributions or, alternatively, as a loan to D.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 23d Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Mary C. Danylak, Timothy Fontenot, James A. Keller, and Brian B. Martin, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.