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If you own a business and you plan to loan money to the company, be sure to consult an attorney about the paperwork. Otherwise, the IRS could claim the money wasn’t a loan after all, and come after you for additional taxes.
Fred Blodgett found this out the hard way. Blodgett owned a small company (an S corporation) that sold architectural glass blocks. When the real estate downturn hit, he supported the company by transferring money to it from a family trust. He called this a loan. In subsequent years, the company paid him about $60,000, which he called a loan repayment.
Not so fast, the IRS said. According to the IRS, the “loan” wasn’t a loan at all, but a simple contribution of capital. And the “repayment” was actually just ordinary wages for the manager of the business. Therefore, the IRS claimed, the company owed more than $13,000 in employment taxes and penalties.
The U.S. Tax Court sided with the IRS. Although the money that Blodgett transferred to the business could have been a loan, the court said, Blodgett blew it because he didn’t create a paper trail showing that a bona fide loan was being made. There was no written loan agreement, no interest, no repayment schedule, and no collateral.
Although this case involved an S corporation and employment taxes, the IRS can also reclassify a “loan” in other ways, such as taxable compensation or taxable dividends.
If you’re thinking of making a loan to a business, be sure to treat it as a loan. Ideally, a written loan document should specify the repayment terms and schedule, interest, security, and subordination rights. Also, the loan shouldn’t be so large in relation to the company’s other operating capital that the IRS can argue that it’s commercially unreasonable.