The Internal Revenue Service regularly scrutinizes loan transactions involving shareholders and other corporate insiders. This is especially so with small, closely held companies. Like yours.
Why play loose with these transactions? The IRS checks carefully to see if loans are actually shams intended to create favorable tax situations for shareholders without having any actual commercial validity (substance) for the loan or corporation. If the transaction appears to the IRS as a capital infusion instead of a loan, they can and routinely do recharacterize loan repayments from the company to a shareholder as dividends. The result: the shareholder is assessed additional taxes (plus fines, penalties and interest) on the principal repayments and the interest they received.
Insiders (shareholders, directors and officers) may avoid such adverse tax treatment by making all their loans commercially beneficial to the corporation, and supported with bona fide documentation such as a promissory note pre-approved by action of the board in adopting a specific resolution approving each separate loan. Especially loans and transactions between the corporation and its insiders.
Was that redundant? Yes? I get that from a lawyer’s opinion I read many years ago where he said to “overdocument” such transactions.
Itchy [Big] Brother
IRS is itching to recharacterize corporate insider loan transactions where the board or officers (primarily the elected corporate secretary) neglected to record the proper documentation in the minutes. To be upheld, a loan transaction should include a valid creditor/debtor relationship between the parties involved, i.e. the corporation and the insider/shareholder/lender, in this discussion. Every loan requires board of director minutes that record their actions to authorize and approve by resolution the loan and its specific terms, together with the promissory note that reflects the same terms.
Additionally, the loan must be commercially reasonable. That is, it should be for a reasonable term, at a commercially reasonable rate of interest (probably at or a bit above the prime rate), with a reasonable repayment plan or schedule. It should include the corporation’s unconditional promise to repay the loan principal and interest. It should have a fixed maturity date, preferably short term (less than ten years). And, it should not impair the corporation’s ability to continue its operations, or make repayment contingent on future corporate earnings. Without these elements, the IRS is likely to disregard a loan and recharacterize it in a way that is beneficial to the Treasury (i.e. in their favor).
Small, closely held corporations frequently look to their shareholders when they need to borrow money. Shareholders are frequently willing and able to make loans to their corporation. Of course, small companies can borrow money from outside conventional sources, such as banks or venture capitalist, but this can be more complicated and onerous, with the lenders often asking shareholders to personally guarantee the loans.
Wherever a small company gets its loan, there are certain formalities that should be observed and recorded on the official record (the minutes). The board of directors should consider and act on a loan proposal by adopting a resolution that specifically authorizes and approves the loan, its terms and associated paperwork. If the corporation has outside investors, typically people who are not shareholders, directors or officers, it may be very important to also seek shareholder approval and ratification of the loan approved by the directors. It is best to get approval from the board and the shareholders before the actual loan is funded.
Any time a corporation borrows money, it is a serious event. When the corporation borrows money from and insider – a shareholder, director or officer – it may be necessary for the officers or directors to seek legal and tax advice from a professional advisor such as its lawyer or accountant or both. If the loan is sizable, and the terms are lengthly (a repayment schedule that is longer than ten years), it is always wise to have the terms and conditions, including the proposed paperwork, reviewed by the professional or licensed advisors.
The process for approving a corporate loan received from an insider is similar to that when the loan comes from a bank or other conventional lender. However, it is common for conventional lenders to have a pre-determined set of loan docs, including their own form of directors’ resolution, perhaps forms for shareholder approval and ratification of the board’s resolution, and their own preferred form of promissory note, collateral agreement, and loan application. In that case, most of the paperwork is done for you.
Insider loans should closely resemble outsider loans. That is, they should appear on their face, and actually be, arm’s-length transactions. The difference under discussion here is, the insider loan paperwork will normally need to be prepared in-house by the corporate secretary, another corporate officer designated by the board to attend to the task, or by the corporation’s legal counsel. A formal directors’ resolutions is required, and a promissory note that contains the details for repayment is the least that is necessary to have on file in the corporate records book. Properly documenting each transaction, including memorializing the commercial validity and benefit to the corporation, is an essential part of the process that should be carefully filed in the official minutes. This can become particularly important in the future should any dispute arise over the validity, use, purpose or other dispensation of the borrowed funds. Undocumented loan details often result in confusion that leads to trouble between insiders and outsiders. Memories of a loan transaction’s terms can vary widely between a borrower and the lender. The solution and best way to resolve any contradictions or misunderstanding is by keeping an accurate record of the resolution and details related to it. That record lives in the official company minutes book.
Consider the following example of an insider loan that ended up a disaster for the corporation and the inside lender. A shareholder loaned his corporation money that the shareholder had sitting in his personal bank account. This was done rather informally, without any authorization, approval or even a reference or description recorded in the proceedings of the board of directors. Over time, the corporation repaid the loan in full. Later, the corporation was notified of an income tax examination. The revenue agent’s initial notice of audit had attached to it the standard IRS form 4564 (Information Document Request) specifically directing that “copies of all documents, including all records of all corporate meetings, minutes and resolutions that pertain to all loans and other transactions between the corporation and its shareholders, directors, officers and any other third-parties” be produced for examination at the audit. Predictably, the revenue agent, following, of course, the instructions in his official IRS corporation audit manual that is his roadmap for this process, recharacterized the loan as actually being wages or dividends the corporation had paid to the insider shareholder. Not the repayment of principal the corporation and taxpayer contended for. In the audit determination letter, the revenue agent proposed to recharacterize the loan because: 1) there was no record of the “loan” being authorized and approved by a board resolution filed in the official company minutes; 2) the “loan” was not disclosed on the corporation’s income tax return; and, 3) there was no record that a promissory note was prepared, signed and kept by the corporation.
This is a classic example that demonstrates the need to follow proper procedure and observe the formalities for recording directors’ actions in minutes and resolutions. Especially in situations involving corporate insider transactions. The boiled-down protocol is generally this:
1) give the board and the shareholders full disclosure of all insider transaction details, particularly when the transaction is financially beneficial to an insider;
2) make the disclosure in advance of any official board acts, approvals, authorizations and resolves;
3) do the paperwork and record the board’s resolutions in the minutes, including their approval of the specific promissory note, terms of repayment, commercial viability, corporate interest and use for the borrowed funds, and other disclosures that can be clearly referred back to in the future; and
4) get unrelated outsider shareholder approval in writing and on the record – in the minutes – where they acknowledge they understand the nature of the insider transaction, they approve it, and they ratified it.
The board’s resolution is an essential element of corporate governance for all insider transactions. Neglecting this formality is like asking a judge or revenuer to please disallow the loan because it lacks substance, then recharacterize it as a taxable transaction, and finally rule that the company is the insider’s alter ego. That being done, they can hold the insider personally liable for all the corporation’s taxes, obligations and debts. Creditors can then ask for a judgement, charging order, wage attachment, asset seizure and other creative remedies to collect from the insider’s personal assets.
Instead, you could just do the paperwork. Observe the formalities. Follow protocol. Otherwise, your corporation cannot provide reliable shelter from attacks from creditors, auditors and litigators. The corporate “veil” will be pierced. Game. Set. Match.
In cases where an IRS income tax audit results in an unfavorable letter of determination for the corporation and the taxpayer/shareholder/insider, there is a silver lining . . . albeit for the revenuers. IRS will notify your state income tax authorities of their federal income tax determination and notice of tax deficiency (with additional fines, penalties and interest). If either the corporation or taxpayer/shareholder/insider has a nexus with, say, the state of California, why, then think: California Franchise Tax board audit. Likewise, in reverse. If the California FTB finds a deficiency in their state income tax audit, they notify the Feds of their finding, and then they will be compelled to follow up with an IRS exam of their own. Otherwise, they’re just leaving money on the table, so to speak.
See? It can always get worse.
Forewarned is forearmed.
*This is the fourth and final installment in a series of posts that focus mainly on loans that “insiders” give to or get from their corporations. The information is not exhaustive, but hopefully it will help you better understand general principals to consider when dealing or self-dealing with your small, closely held business company or incorporated professional practice. My posts are not offered or intended as legal or tax advice. For that, always consult a qualified licensed legal or tax advisor, or both. If you read this first, you may be better able to discuss this subject with your professional advisors.