Tax Tips

What makes the IRS automatically suspect that a loan may not be a true loan?

Answer: The loan is suspect when you make that loan to your wholly owned corporation or to your brother, mother, or grandfather.

If the loan is not a true loan because you improperly documented it, executed it, or otherwise failed to prove loan status, then it is a fake loan for tax purposes.

The problem with a fake loan to a corporation or other business entity that you own is that the dollar amount of the fake loan becomes a capital contribution.

If you make the fake loan to your brother or mother, it becomes a gift for tax purposes.

When you make a valid loan that does not get repaid, you deduct your loss in full as a bad debt. When a fake loan goes bad and does not get repaid, you lose the bad debt deduction and,

-In the case of a relative, deduct zero because you made a gift; or,

-In the case of your corporation, face the $3,000 capital loss ceiling on your aggregate capital investments in your corporation, including the fake-loan investment.

This article gives you guidelines that help you make sure that your loan is a real loan for tax purposes.

What Is a Real Loan?

Tax law allows you to deduct bona fide debts owed to you that become worthless within the taxable year.1

Bona fide debts arise from debtor-creditor relationships based on valid and enforceable obligations to pay a fixed or determinable sum of money.2

A gift to a relative or a contribution to the capital of your corporation or other entity does not constitute bona fide debt.3

You carry the burden of proof both that a bona fide debt existed and that the debt became worthless in the year you claim the deduction.4

To make sure you document your loans properly, answer the following nine questions

1.How should you name the documents that evidence the loans?

2.Should you require fixed maturity dates or use ?on demand? maturities?

3.What will the borrower use as a likely source of repayment?

4.Will you participate in management of the borrower?

5.How does your loan stack up compared with debts owed to other creditors?

6.Is the debtor thinly or inadequately capitalized?

7.How do the parties treat interest?

8.What is the borrower?s ability to obtain loans from outside lending institutions?

9.What will you do if the borrower fails to repay the loan?

Use these questions and the answers below to assist you in making real loans and not fake loans that become gifts or capital investments.

Consider the following:

A stock certificate indicates a capital contribution; a note indicates bona fide debt.

The sole shareholder who transfers funds to his closely held corporation is subject to heightened scrutiny, and labels attached to the transfers through bookkeeping entries or testimonies have limited significance without the support of objective evidence

-A gift (producing no deductions for you);

-A capital contribution (producing nothing for you until you sell the corporation).

What should you do? At a minimum, spend $5 at the local office supply store to buy a standard loan agreement; then spend the time to properly complete that agreement to create strong evidence of the debt.

A fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation. The absence of a fixed maturity date indicates that repayment is in some way tied to the fortunes of the business, indicating a capital investment

With a relative, the absence of a maturity date indicates a gift.

Your best practice is to use a fixed maturity date on your loans.

The ability to repay indicates a loan. Repayments based on future profits indicate a capital investment

When you look at the loan, do you have a reasonable expectation of repayment in light of the economic realities of the situation?

A ?yes? answer indicates a bona fide loan.

Say you transfer money to a corporation and, as a result, earn an increased right to participate in the management of the corporation.

Your management participation suggests that the advance was not a bona fide loan, but rather a capital investment

If you subordinate your loan to a loan from an outside creditor, it looks less like a loan

Even worse, if you fail to demand timely repayment while other creditors are receiving timely payment, you look even less like a lender

Say your corporation cannot borrow any more money from outside unrelated sources and has pledged all its assets as security for existing loans. The corporation needs money, and you are the one and only hope, the last possible source

You lend the money with no security to back up the loan?something no outside lender would do.

In this case, you don?t look much like a lender; rather, you look very much like a desperate owner.

If your corporation does not have the operating capital it needs to operate, the courts and the IRS will look at your loan to the corporation as a possible capital investment

Similarly, if your relative does not have the resources or the ability to repay your loan, it looks as though you are making a gift.

True lenders want interest income

Fake lenders might want corporate earnings. One court noted that shareholders who transfer sums to a corporation and do not insist that the corporation make interest payments indicate that they expect payment from future earnings or through the increased market value of their equity.

Parents indicate that they are making gifts when they transfer monies to their adult children and do not require interest on the monies.

Here is a touchstone of economic reality. Ask yourself this question:

Would an outside lender make the loan and accept payments in the same form and on the same terms?

This is just one factor, and failing this one factor does not make the loan fake. The fact that a loan could not be obtained from an unrelated source does not preclude the existence of a bona fide debt

However, when you cannot say that an outside lender would have made this loan, you do put your loan assertion in peril when attempting to deduct a bad debt.

is where the rubber meets the road. Say your loan has no fixed dates for repayment, you never ask for payment, and your relative or your corporation goes bankrupt. You are in deep doodoo. Your loan is a fake. It is not a loan. You are not going to qualify for the favorable bad-debt deduction should the loan go south.

Lenders intend to get paid. Repayment is an essential element of a loan

When you lend money to a relative or your solely owned corporation, you automatically become suspect as a person who might not require repayment.

If any part of the loan or interest becomes delinquent, you must take action to enforce the loan or you may not have a loan.

Example:Your corporation is making payments on a loan from the bank, but not making the required payments on a loan from you. Presto, you probably have a capital contribution, not a loan.

If you have a set date for payments and those payments are not collected, you need evidence of your collection efforts. And those efforts should show that you acted like a real lender who really wanted to collect.

Making loans to relatives and closely held corporations requires attention to the details. Review the nine questions above and set up your loans accordingly.

Keep in mind that your loan does not have to satisfy all nine questions, but it should look, act, and be treated by you and the borrower like a real loan. Use the nine questions as a guide.

The best way to ensure that a loan is considered bona fide by the courts and the IRS is to

-put the loan terms in writing;

-require fixed payments with principal and interest;

-make sure you collect the payments on time;

-assess late fees for late payments; and

-be merciless in your collection efforts.