Payments to S Corporation Shareholder Were Loan Repayments, Not Disguised Wages

Normally when we discuss a case of an S corporation shareholder who performed services for the entity, reported no salary but received cash we end up with a finding by the Court that the payments represented disguised salary.  But that is because, normally, the shareholder has been trying to argue the payments represented a distribution from the S corporation.

In the case of Scott Singer Installations, Inc. v. Commissioner, TC Memo 2016-161 the taxpayer did not argue that the payments represented distributions and, in fact, the taxpayer agreed that, as a corporate officer, he would be an employee of the corporation.  But the taxpayer argued in this case that the payments amounted to repayments of loans he had made to the corporation—and the Tax Court agreed with the taxpayer.

The IRS was skeptical of the view that there had actually been loans made to the S corporation, though not that funds had been advanced to the corporation.  Rather the IRS found that those advances were capital contributions instead of loans—and, thus, the payments were not repayments of loans.

The Tax Court noted that the question of whether advances are capital contributions or loans must be evaluated on a case by case basis, taking into account all facts and circumstances.  The opinion notes:

Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include: (1) the names given to the documents that would be evidence of the purported loans; (2) the presence or absence of a fixed maturity date; (3) the likely source of repayment; (4) the right to enforce payments; (5) participation in management as a result of the advances; (6) subordination of the purported loans to the loans of the corporation's creditors; (7) the intent of the parties; (8) identity of interest between creditor and stockholder; (9) the ability of the corporation to obtain financing from outside sources; (10) thinness of capital structure in relation to debt; (11) use to which the funds were put; (12) the failure of the corporation to repay; and (13) the risk involved in making the transfers. Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 285 (1990); see also In re Lane, 742 F.2d 1311, 1314-1315 (11th Cir. 1984).

The Court then boils down the test to a simple question:

However, the ultimate question is whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

In this case, the Court outlined the facts as follows:

In order to fund petitioner's growth, Mr. Singer began raising money from various sources. In 2006 Mr. Singer established a $224,000 home equity line of credit. In less than a year Mr. Singer had drawn on the entire line of credit and advanced the funds to petitioner. In 2006 Mr. Singer also established an $87,443 line of credit by refinancing a home mortgage. He likewise advanced the entire amount to petitioner within the same year. In 2008 Mr. Singer established a 115,000 general business line of credit and advanced all the funds to petitioner. Mr. Singer also borrowed $220,000 from his mother and her boyfriend and advanced all the funds to petitioner throughout 2007 and 2008. In sum, Mr. Singer advanced a total of $646,443 to petitioner between 2006 and 2008. Petitioner reported all of the advances as loans from shareholder on its general ledgers and Forms 1120S, U.S. Income Tax Return for an S Corporation, but there were no promissory notes between Mr. Singer and petitioner, there was no interest charged, and there were no maturity dates imposed.

The Court noted, though, that while the business was initially profitable, following the 2008 real estate crisis the company’s fortunes took a nasty turn for the worse.  That forced the taxpayer, who no longer could obtain any commercial financing, rather now obtaining money from this mother and her boyfriend.

The Court noted that the corporation had always reported the amounts in question on its books as loans on its books and tax returns, though no interest had been charged, no notes signed and no maturity dates established.  Despite those issues, the Court found that through 2008 the advances did represent loans—the evidence suggested the shareholder intended to be repaid these funds and it was reasonable to believe the corporation would do so.

However, the Court found that the later advances represented capital contributions, as the large operating losses no longer made it reasonable to assume that the corporation would be able to repay the advances.  Even though the Court found the shareholder still intended for these advances to be loans, the lack of a reasonable prospect for repayment rendered the payments capital contributions. 

As the opinion notes:

When neither petitioner nor Mr. Singer was able to raise funds from unrelated third parties, Mr. Singer must have recognized that the only hope for recovery of the amounts previously advanced to petitioner was an infusion of capital subject to substantial risk. After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards. No reasonable creditor would lend to petitioner. Accordingly, we find that advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were more in the nature of capital contributions.

But the good news for the taxpayer was that the amount of payments in question for the years under exam were less than the amounts the Court had found represented loans—and thus the Court found no salary payments to the shareholder.