Using loans to extract cash from a closely held corporation.

• Author: Ellentuck, Albert B.

Lending corporate cash to shareholders can be an effective way to give the shareholders use of the funds without the double-tax consequences of dividends. However, an advance or loan to a shareholder must be a bona fide loan to avoid a constructive dividend. Further, the loan must have an adequate interest rate to avoid deemed dividends under the below-market loan rules of Sec. 7872.

Establishing a Bona Fide Loan

Whether withdrawals from a corporation are loans or distributions depends on whether, at the time of the withdrawal, the shareholder intended to repay. the amounts received and the corporation intended to require payment. It is not enough for a shareholder to declare that he or she intended a withdrawal to be a loan. There must be more reliable evidence that the transaction is debt. Some of the factors used to determine whether an advance should be treated as a loan or a dividend include:

1. The extent to which the shareholder controls the corporation. If a shareholder has unlimited control of a corporation, it is likely that loans will not be arm's-length transactions. Therefore, a greater potential for disguised constructive dividends exists. In determining control, both direct and indirect stock ownership must be considered.

2. The earnings and dividend history of the corporation. A corporation's history of not paying dividends despite the existence of sufficient earnings and profits may indicate that loans to shareholders should be considered constructive dividends, particularly where other evidence of indebtedness is lacking.

3. The magnitude of the advances and whether a ceiling existed to limit the amount. The lack of a ceiling limiting the amount a shareholder can withdraw from the corporation is indicative of a constructive dividend rather than a loan. In addition, sizable advances in relation to corporate profits or shareholder salaries may also be evidence that a distribution is not a loan.

4. How the parties recorded the advances on their books and records. The fact that distributions are recorded on the corporation's books and/or the shareholder's personal financial statements as shareholder loans is some evidence that they should be considered loans. However, the Tax Court has stated that this factor is not determinative without further evidence substantiating the existence of a bona fide loan (Baird, 25 T.C. 387 (1955)).

5. Whether the parties executed notes. While a formal note is evidence that a shareholder distribution...