To claim a bad debt deduction, a corporation must establish that a debt actually exists. A bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money [Reg. 1.166-1(c) ].
A formal loan agreement is not absolutely necessary to create a bona fide debt ( Andrew ). Also, the giving of a note or other evidence of legally enforceable indebtedness is not in itself conclusive evidence of a bona fide debt. The corporation must be able to show that it was the intent of the parties at the time of the transfer to create a debtor-creditor relationship. In other words, the corporation must be able to show that at the time of the transaction, it had a real expectation of repayment and intent to enforce the collection of the indebtedness ( Rodgers ).
In Shaw , the Ninth Circuit Court of Appeals upheld a Tax Court decision disallowing a bad debt deduction for the taxpayer’s advances to her family-owned business. In reaching its decision, the Court found that the taxpayer’s behavior was not consistent with that of a traditional lender, as evidenced by the fact that the taxpayer continued to advance money to the family-owned business despite its unstable finances, the company’s failure to repay any interest or principal, and the taxpayer’s failure to demand repayment.
Taxpayers’ advances to a closely held corporation were ruled to be below market loans subject to IRC Sec. 7872 and bad debt treatment was denied since the debts had value based on the facts that the corporation repaid a large portion of the debt in one year, and the taxpayers continued to make advances in other years, recorded the advances as loans on the books and records, and never pursued collection until after the IRS audit ( Hoffman ). When the loan is to a shareholder and the corporation has no real expectation that the shareholder will repay, the amount may be subject to reclassification as a distribution.
Note: Loans to or from shareholders (or other related entities) should always be represented by a formal note. The note should bear a fair rate of interest minimally equal to the IRS’s Applicable Federal Rate (AFR) and should be authorized in the corporate minutes. AFR rates are published every month on the IRS website and can be found by typing “Applicable Federal Rate” in the search box. If the corporation made advances to a shareholder during the year, a formal note should be executed for the advanced amounts. See Key Issue 10D for further discussion.
Factors that the courts consider in determining whether a bona fide debt exists as the result of a transfer between related parties include—
1. the presence or absence of documentary evidence of the transaction (such as an executed note),
2. whether there is a fixed schedule for repayment (including a maturity date),
3. whether interest is being charged on the outstanding debt,
4. whether collateral is obtained or requested,
5. whether demand for repayment is made,
6. whether any repayments have been made,
7. whether the transaction is reflected as a debt in the records of the parties,
8. the financial condition of the debtor at the time of the loan (so that the lender can show the expectation of repayment and intent to create a valid debtor-creditor relationship),
9. the ability of the corporation to obtain credit from outside sources,
10. whether there has been a change in the interest held (i.e., debt to stock), and
11. whether the lender has the right to participate in management as a result of the advances.
See Schmieder ; Goldstein ; and Brazoria County Stewart Food Markets, Inc. for additional discussion of the factors to consider. Bona fide debt is also discussed in Key Issue 10D .
For loans made by a corporation to a related shareholder, the IRS will consider the prior dividend history of the corporation, including whether the corporation has adequate earnings and profits (E&P) to make a distribution. If the corporation has adequate E&P, but has never made a distribution to the shareholder, the loan may be a constructive dividend. The IRS will also consider the magnitude of the advances made, including whether the corporation has set a ceiling on the amount that it will loan. Another indication of a constructive dividend is the annual reissuance of a term note for previous amounts owed, including interest. The practitioner must consider all factors together. No single factor is determinative of whether a bona fide debtor-creditor relationship exists.
Regulations under IRC Sec. 385 address when debt in a related corporation may be recharacterized as equity. The regulations apply to debt instruments issued by a domestic corporation (or a disregarded entity owned by a domestic corporation) and held by a member of the corporation’s expanded group. An expanded group includes members of an “affiliated group” defined in IRC Sec. 1504(a) as one or more chains of corporations connected through a common parent that owns 80% of each corporation [Reg. 1.385-1(c)(4) ]. The regulations do not apply to foreign issuers (including controlled foreign corporations), S corporations, noncontrolled regulated investment companies (RICs), and real estate investment trusts (REITs), or debt instruments held by members of the same consolidated group.
Subject to certain exceptions, the following will be recharacterized as equity: (1) a note distributed to a related shareholder; (2) a note issued to acquire stock in a related entity; and (3) a note distributed to a related entity in an asset reorganization [Reg. 1.385-3(b)(2) ].
See Illustration 10-1 for a list of factors indicating whether corporate advances to shareholders should be considered loans or dividends. Checklist C201 provides a list of factors that should be considered when a corporation loans money to its shareholder(s) to ensure treatment as valid indebtedness for tax purposes.
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