Question

34. Combat Toys Inc. has an accumulated deficit and current E&P of $20,000. Joe Gunn, a 60 percent shareholder, withdrew $35,000 from the corporation. Joe reported no income from the transaction, and upon audit he claimed it was a loan. No note had been executed, but on the eve of the audit, Joe signed a demand note for $35,000, payable to Combat Toys. The IRS claims Joe has a dividend of $35,000. What is the most likely result if the case goes to court?

Answer 1

If the Case goes to Court

The court will say the shareholder used the corporation "as a deep pocket from which he could extract funds at will and deposit funds at his convenience.” The withdrawals were taxable as ordinary income because the company was a C-corporation with sufficient current and accumulated earnings and profits. If the withdrawals had exceeded earnings and profits, they would first have been applied to reduce stock basis, and then been taxed as capital gains. If the corporation was an S-corporation, the withdrawal would have first been tax-free reductions of its accumulated adjustments account; then, the tax consequences would generally have been the same as for a C-corporation.

If they had been treated as bona fide loans, they would have been tax-free.

The test for whether a withdrawal is a loan is whether, at the time it was made, the shareholder intended to repay it and the corporation intended to require repayment. Further, charging interest for the loan solidifies the borrowing nature of the transaction and the Court can “impute income” to the borrower by imposing what the reasonable interest rate would have been and insisting that taxes should have been paid on it by the corporation…or declining to treat the transaction as a loan at all, as here.

From the above it is clear that, it is not enough proof that each owner can testify that the requisite intent was there. There are many factors that the courts examine when trying to decide whether a shareholder withdrawal is a loan. Most of these factors are within the shareholder's and corporation's control. It is not necessary that each one of the factors be present to indicate a loan, but taken together they must be able to overcome the IRS's presumption that the correct treatment is a dividend or distribution.