Business Workshop: Is it a loan or equity?
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The owners of small and start-up businesses often loan money to their companies. If it doesn't work out, they figure they can always claim a bad debt on their personal income tax.
But claiming that bad debt is not a cut-and-dried matter, as shown by a recent ruling of the Tax Court that was upheld by a U.S. Court of Appeals.
A business owner tried to take a bad-debt deduction for loans to the company, and credit card and other payments he had made on behalf of the company. But the tax and appeals courts both ruled that the loans and the payments were really equity investments.
The courts reasoned that the owner and the business didn't have documentation to demonstrate that there was an interest rate and a repayment schedule. In addition, the company was unable to borrow money from an outside source and did not have the revenues to repay the loan, meaning that repayment could only come if the company raised more capital.
The case demonstrates that when business owners loan money to their business, they must fully document the transaction.
Important documentation includes:
• A formal loan note that has been signed by both parties.
• A fixed schedule for repayment, including applicable interest, payment dates and a date of maturity.
• A careful record of repayments. If no repayments have been made, the Internal Revenue Service may conclude that the funds were an equity investment and not a loan.
In other words, the business should treat the loan the way it would treat any loan from a bank. Otherwise, if the business goes bad, the owner who loaned the money may find that the IRS will disallow the personal deduction for bad debt.
-- Herb Wolfson, Wittlin
Simon & Newman
First Published December 3, 2012 12:00 am