A failure to properly document transactions between parties can result in a surprising tax bill. The Tax Court recently heard on a case involving this type of issue. The case involves an attempt to write off business expenses without proper documentation.
The business at issue was owned by a husband and wife. The husband owned 49 percent of the business, an S-corporation. The wife was the majority owner with 51 percent. The husband also owned two additional businesses. The husband used funds from one of his own businesses to pay off debts of the business owned jointly by himself and his wife in 2010. Shortly thereafter, the husband added a note within his business’ ledgers stating the transaction as a loan. In 2011 the husband made additional payments from his own business to cover a portion of the jointly owned venture’s debts. He listed the transfer as a distribution within his business’ ledgers.
The couple claimed the transactions as business losses and attempted to deduct the losses on their 2011 tax returns. The IRS disagreed with this claim and denied the deductions. Instead, the agency treated the deduction as a constructive dividend. As such, the agency stated the couple owed a tax on the transfer and penalties for underreporting.
A constructive dividend occurs when a corporation pays a shareholder from available earnings without an expectation of repayment. To determine if the transfer is a loan and not a constructive dividend, the court will consider many factors. Examples include:
- Documentation. The court will look for a note or other form of documentation to establish a repayment promise.
- Formality. An analysis will also include a review for the presence of interest and collateral.
- Reasonableness. The court will likely consider the likelihood of the party to repay the loan.
In this case, the court points out the husband’s business did not execute a note to document the alleged loan, did not set an interest rate and failed to provide any collateral. Ultimately, the court ruled in favor of the IRS on this issue and found the transactions were capital contributions not loans.
A failure to properly document transactions of this nature can result in tax controversies. Business owners can seek the counsel of an experienced attorney to help mitigate the risk of this type of controversy.