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Shareholder loans and the required accompanying documentation are facing increasing scrutiny by the IRS. Any potential deduction that may arise from a worthless shareholder loan must be substantiated by documentation confirming a valid loan exists. When entering into loan agreements with related parties it is important that all notes are expressed in the form of a written formal note, indicate a reasonable interest rate, and authorized in the corporate minute book. Besides having the written documentation, the taxpayer is also responsible to be sure that the terms of the note are being adhered to.

A recent court case, Shaw, T.C. Memo 2013-170, disallowed a bad debt deduction due to the taxpayer not being able to prove that loans were actually bona fide loans or that they became worthless in the year deducted. Although a note was executed and contained a reasonable interest rate, no interest or principle was ever paid. The service will often consider payments made to a related entity as capital contributions. In this case, the court found that Shaw’s behavior was unlike that of a bona fide lender as she made no formal attempt to collect on the loan.

The Shaw case is an example of not establishing a debtor-creditor relationship. Common factors which will be considered when the validity of loans are in question include, but are not limited to, documentation of the existence of the transaction, affixed schedule of repayment, whether interest is required on the loan, whether collateral is obtained or requested, whether demand for repayment is made, and the financial condition of the debtor. As was the case in the Shaw decision, the financial condition of the company and lack of collateral did not satisfy the third party lender requirement and therefore they failed to establish a valid debtor-creditor relationship between related parties. The debt was reclassified as a capital contribution.

It is common for shareholders to loan entities money during cash flow shortfalls and times of increasing growth. Therefore, it is very important that shareholders are protecting themselves by following the standards set forth by the IRS. When entering into related party loans, try to place the same scrutiny upon your loan as an unrelated lender would. Ask yourself if a third party would see you as a bona fide lender conducting an arm’s length transaction and most importantly seek the guidance of your professional advisors.

If you have any questions, please contact your local UHY LLP professional.