Avoiding Tax Problems with Shareholder—Corporation Loans

Owners of closely-held corporations will often either borrow money from the corporation or lend money to it.  Many times these arrangements are informal and not carefully documented.  In such cases it can appear as though the corporation’s bank account is functioning as if it were another personal account of the shareholder or vice versa.  These loose arrangements are problematic from an income tax point of view because the corporation and the shareholder are treated as distinct persons for tax purposes.

Poorly documented amounts borrowed from a corporation may be deemed instead by the IRS as a distribution.  For a C corporation, a deemed distribution is a dividend taxable to the shareholder and not deductible to the corporation.  For an S corporation, a deemed distribution may give rise to a potential second class of stock problem that could invalidate the S election, or perhaps the IRS might treat the deemed distribution as compensation subject to payroll taxes normally avoided by true S corporation distributions.

On the other hand, poorly documented amounts loaned to the corporation may be deemed instead by the IRS as a contribution to shareholder capital.  A contribution of capital cannot be repaid to the shareholder like a loan can be.  Instead repayments are treated as distributions to the shareholder with the applicable treatment depending upon the classification of the corporation.

In order to avoid these kinds of problems with shareholder—corporation loans, be sure to observe the following factors that have been considered by the courts when ruling on disputes between taxpayers and the IRS.  The main factor in determining whether the transaction is a loan for tax purposes is whether the parties intend for the money to be repaid.  Such intention should be contemporaneously evidenced as follows.

1.       Is there a promissory note or other written obligation promising repayment?

2.       Is adequate interest being charged?

3.       Has a fixed schedule for repayment and maturity date been established?

4.       Has collateral been given to secure repayment?

5.       Have repayments actually been made?

6.       Is there a reasonable prospect that the borrower can repay the loan?

Another factor to consider is this:  if the shareholder does not respect the separate existence and legal form of the corporation, will the corporate “veil” of limited liability be pierced if there is a third-party lawsuit, putting the shareholder’s personal assets at risk?

New “Simplified” Option for Deducting Home Office Expenses

Certain home office deductions are permitted for businesses run out of an individual’s home.  However, to be eligible for home office deductions, two basic requirements must be met:

1.     Regular and Exclusive Use:  You must regularly use part of your home exclusively for conducting business.  This test can be difficult to meet if the business part of your home isn’t separated from the personal part of your home such as by a door or by a separate structure.

2.     Principal Place of Your Business:  If business is conducted outside of your home, you can still qualify if you can show that you also use your home substantially and regularly to conduct business.  For example, you might have in-person meetings with clients or customers in the home.

The business home office deduction cannot exceed gross business income less other business expenses.  Any excess home office deduction can be carried over to the next year.

If you are not the business owner, but are an employee, then in addition to the above two tests, you must also meet the following two tests:

3.     Your business use must be for the convenience of your employer.  If the use of the home office is merely appropriate and helpful, you cannot deduct expenses for the business use of your home.

4.     You may not rent any part of your home to your employer and use the rented portion as the employee.

Starting with 2013 tax returns a new simplified option is available.  Instead of keeping track of actual expenses and prorating by the percentage of the square feet of your home used for business, a flat rate prescribed by the IRS multiplied by the business square footage can be used.  The simplified option does not change the above rules for qualifying for the home office deduction.  Rather, the method is like a standard deduction:  a $5.00 rate times up to 300 square feet (roughly 17 by 17 feet), or $1,500 is permitted.  You can choose each year to use either the regular or the simplified method.  Once selected, the method cannot be changed for that tax year.

Benefits of the simplified option include:

1.     Mortgage interest and real estate taxes can be deducted in full as itemized deductions.  They are not considered part of the $5.00 rate.

2.     The $5.00 rate is not considered to include home depreciation (and none may be claimed under the simplified option), so there is no depreciation recapture if you later sell your home.

3.     The $5.00 rate does not reduce other business deductions that are unrelated to the home.

Disadvantages of the simplified option include:

1.     The business square footage is limited to 300 square feet.

2.     Any excess home office deduction above business net income may not be carried over to the next tax year.

3.     No home depreciation deduction can be claimed.  If actual expenses are used in a later year, depreciation is computed using the optional depreciation table as if there had been no interruption in depreciation years.

4.     A carryover of unused home office deduction from an earlier tax year may not be claimed.

Despite the limitations imposed on the simplified option, some taxpayers may benefit from it.  More information can be obtained by referring to RevenueProcedure 2013-13, IRS Publication 587, or Form 8829.