Shareholder Loan Documentation

By John W. Lindbloom, CPA/PFS, Huber, Ring, Helm & Co., P.C., St. Louis, MO

Editor: Alan Wong, CPA

Gross Income

Once again the Tax Court reminds taxpayers of the importance of details and following document terms for shareholder loans (Todd, T.C. Memo. 2011-123). The court determined that an amount purportedly borrowed by the sole shareholder of a corporation from its welfare benefit fund was a taxable distribution to the shareholder and not a loan.

The taxpayer was an employee and sole shareholder of the corporation. He was also its president and director. The corporation also employed several other individuals. All employees were covered under a collective bargaining agreement. The corporation, under the terms of the union contract, provided a death-benefit-only plan funded by life insurance through a welfare benefit fund. The taxpayer applied for and obtained a $6 million insurance policy on his life on behalf of the welfare fund. The welfare fund owned the policy, and the corporation paid the annual premiums.

The welfare fund agreement provided that the employer and trustees of the plan had discretion to make loans to participants on a nondiscriminatory basis. Employees were required to submit an application and written evidence of serious financial hardship or a financial emergency. The taxpayer applied for a loan, stating on his application that he was experiencing “unexpected housing costs,” and obtained a $400,000 loan from the welfare fund. The welfare fund elected to reduce the face amount of the taxpayer’s policy in lieu of paying the 4.76% interest rate to the insurance company.

The welfare fund issued a note to the taxpayer that was not signed until six months after the loan was issued. The note provided for interest at market rates; however, the taxpayer was charged only 1% interest. The note also provided that in lieu of the required quarterly loan note payments, the taxpayer could elect to reduce any payment from the fund to the taxpayer or his beneficiary. The taxpayer had not made any payments on the note.

In its opinion, the Tax Court looked to a Fifth Circuit decision—Moore, 412 F.2d 974 (5th Cir. 1969)—which held that “the distinguishing characteristic of a loan is the intention of the parties that the money advanced be repaid.” Factors considered by courts in finding a bona fide loan are whether:

  • The promise to repay was evidenced by a note or other instrument;
  • Interest was charged;
  • A fixed schedule for repayment was established;
  • Collateral was given to secure pay-
  • Repayments were made;
  • The borrower had a reasonable prospect of repaying the loan and the lender had sufficient funds to advance the loan; and
  • The parties conducted themselves as if the transaction was a loan (Goldstein, T.C. Memo. 1980-273).

The court concluded that the $400,000 disbursement from the welfare fund to the taxpayer was taxable income and not a bona fide loan. It analyzed the seven factors listed above and found that five of them were not met, indicating that the parties did not establish a debtor-creditor relationship at the time the funds were advanced.

  • Presence of a note: The parties did not memorialize the debt at the time the welfare fund disbursed the funds. They also did not execute the note until almost four months after the first repayment date. In addition, the parties did not adhere to the terms of the welfare fund agreement and the note. The fund did not charge market rate interest, and the taxpayer did not make quarterly payments.
  • Interest rate: The welfare fund charged the taxpayer 1% interest, not market rate as provided for in the note. By comparison, the insurance company would have charged 4.76% on a similar loan.
  • Repayment schedule: The welfare fund did not provide the taxpayer with a repayment schedule reflecting the quarterly payments until three months after the first payment was due.
  • Collateral: The court found sufficient collateral in the alternate repayment provisions allowing the fund to reduce the death benefit to the taxpayer’s beneficiaries.
  • Repayments: The taxpayer did not make any repayments on the note. The court rejected the taxpayer’s argument that the option to reduce any benefits due to him or his beneficiaries was valid repayment. Because of the nature of the plan (a death-benefit-only plan), repayment was contingent on multiple future events such as the corporation’s continued participation in the plan, the employee’s continued employment, and continuation of the union agreement. Due to these uncertainties, the taxpayer could not rely on the death benefit as a form of repayment.
  • Prospect of repayment: The court found a reasonable prospect of repayment because the taxpayer earned a substantial income.
  • Parties’ conduct: Neither party acted in a manner indicating that the disbursement was a loan. Neither party strictly abided by the note’s terms. The fund did not inquire into the hardship the taxpayer claimed on his loan application. The interest rate was below market, and the taxpayer made no quarterly payments. The welfare fund made no attempt to collect the debt when the taxpayer did not remit the scheduled repayments.

This case points out the importance of details in a loan transaction, especially when it involves related parties. In the case of a loan between a corporation and a shareholder, failure to follow terms and provisions will likely result in a loan being treated as a taxable distribution.


Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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