Is Your Advance Debt or Equity? It Matters.

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Business owners often make capital contributions or loans to their corporations.   Debts are paid to creditors including owner-creditors before distributions are made to owners.  So when cash flow is tight or insufficient, having a clear distinction between loans and contributions is important in deciding who gets paid first and how much.
Knowing the difference between debt and equity is also important for tax purposes.  Unpaid debts can give rise to a tax deduction when the debt becomes worthless.  Unreturned equity can only give rise to a capital loss.   Further, drawing a distinction between a business bad debt and a non-business bad debt can be critical.
If a corporation is unable to repay a business debt, the non-corporate business owner can deduct the unpaid debt against ordinary income as a business bad debt in full in the year the debt becomes worthless.  But if the debt is not a business debt, the unpaid advance is treated as a short term capital loss and can only be deducted against ordinary income to the extent of $3,000 per year.
In a recent case, the Court of Appeals for the 9th Circuit concluded that a CEO, who was also a Director and minority Shareholder, could not take a bad debt deduction for advances he made to the corporation.  The court in this case found that the advances were equity investments in the corporation and not bona fide debt.  In making this determination, the Court of Appeals referred to the following factors:

1. The labels on the documents evidencing the indebtedness;
2. The presence or absence of a maturity date;
3. The source of payment;
4. The right of the lender to enforce payment;
5. The lender's right to participate in management;
6. The lender's right to collect versus right of unrelated creditors;
7. The parties' intent;
8. The adequacy of the borrower's capitalization;
9. Whether the owners' advances are in the same proportion as their equity ownership;
10. The payment of interest out of only money available for distribution to owners; and
11. The borrower's ability to obtain loans from outside lenders.

If you intend to advance money to your corporation, you should take the time to prepare promissory notes and other loan documentation to evidence the loan as a business debt.  Documenting the advance as a loan will give you priority over the other owners and, to the extent you take a security interest, may give you priority over unsecured creditors.  Evidencing the advance as a debt may also entitle you to claim a business bad debt deduction if the debt is not repaid in full.  Call or email me at jsenney@pselaw.com or 937-223-1130 if you would like some help with loan documentation or want to discuss this matter further.

AND ONE MORE THING.  Under Ohio law, a “responsible party” is liable for unpaid trust fund taxes such as sales tax or income tax withholding.  This liability extends to late filing charges, interest and penalties as well.  The tax authorities often attempt to treat all officers of a corporation as responsible parties.   If you are a corporate officer, you want to make sure all trust fund taxes (and late filing charges, penalties and interest) are paid in full and on time.   Give me a call or email if the IRS or state tax authorities are trying to collect from you as a responsible party.

Some Positive Tax News– Guest Blogger Joseph Mattera

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While we await possible major tax impacts from further implementation of President Obama’s health care legislation and continuation or lapse of the Bush tax cuts, there is some good news to report this week.  Due to inflation adjustments, the IRS has announced several increases in various tax benefits in 2013 in the areas of gifting, the “kiddie tax” and retirement savings.

Currently, the annual gift tax exclusion is $13,000 per person per donee.  This annual exclusion is the amount you can gift to any number of individuals per year with no gift tax implications.  For example, if you have 3 children, you can gift each child up to $13,000 per year (total gifts of $39,000) under the current exclusion.  Starting January 1, 2013, this annual exclusion amount increases to $14,000.  While this $1,000 per person per donee increase seems small, remember that your spouse can double the annual exclusion amount by joining in the gift (or can make a gift in the same amount), and that you and your spouse can make annual gifts to any number of persons.

For tax year 2012, taxpayers can reduce a child’s unearned income subject to the “kiddie tax” by $950.  For 2013, the number increases to $1,000.  This will permit a child to earn $50 more before being taxed at their parents’ tax rates.

The maximum an employee can now contribute to a 401(k) plan is $17,000.  In 2013, the number will increase to $17,500.  Employees aged 50 and over may continue to contribute an additional $5,500 per year, bringing their maximum to $23,000 per year starting in 2013.

If you have any questions or comments about these tax benefits, please call or email Joseph Mattera at Jmattera@pselaw.com or 937-223-1130.

AND ONE MORE THING.  The BWC offers grants to employers under the Safety Intervention Grants Program, the Drug Free Safety Program, the Workplace Wellness Grant Program and the Transitional Work Grants Program. Sarah Carter can provide more information about these grant programs. If you have any questions or comments about any tax or business matter, please call or email me or Sarah Carter at Scarter@pselaw.com or Jsenney@pselaw.com or 937-223-1130.

Now is a Good Time to Borrow Money from Yourself

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Want to take a bunch of money out of your corporation but don’t want to pay all the taxes that would apply if you took out a dividend or paid yourself a bonus?   Consider borrowing the money from your corporation.

The IRS publishes applicable federal rates (“AFRs”) each month.  The AFRs are the minimum interest rates that the IRS requires be charged on demand and term loans in various situations.  The extremely low interest rate environment of the last several years has produced extremely low AFRs.  For example, for the month of October, the short-term AFR (3 years or less) is 0.23% and the mid-term AFR (more than 3 but less than 9 years) is 0.93%. The long-term AFR (more than 9 years) for October with monthly or quarterly compounding is 2.34%.

Based on the AFR rates for October, you could have your corporation loan you significant dollars for a term of less than 9 years and pay interest on such money at the rate of only 0.93%.  This is way better than taking a taxable bonus or dividend.  Especially if you, like many other small business owners, expect to make additional capital contributions to the corporation from time to time in the future.

But you need to steer clear of pitfalls. The loan must be set up properly to avoid having the loan characterized as a taxable dividend or compensation payment. Some of the key factors for determining when a bona fide loan exists are:

(1) Whether there is a cap on how much can be advanced to the owner.

(2) Whether the owner gives collateral for the loan. Such collateral could be a pledge of the owner’s stock.

(3) Whether the owner is financially able to repay the loan. The owner’s stock in the corporation, other unrelated assets and salary as an employee of the corporation is considered in making this determination.

(4) Whether there is a repayment schedule and whether the owner made any repayments.

(5) Whether there is a definite maturity date.

(6) Whether the corporation makes any effort to collect the loan when due.

(7) The size of the loan.

(8) Whether the owner controls the corporation.

(9) Whether the corporation has any earnings and dividend payment history.

(10) Whether the loan is evidenced by a promissory note.

(11) Whether the corporation recorded and reported the loan on its accounting records and tax returns.

Give me a call or email at 937-223-1130 or jsenney@pselaw.com if you have any questions or comments about shareholder loans, or if you would like some help with properly structuring your loan arrangement.

AND ONE MORE THING.  Don’t forget capital loss carryovers you have from prior years.  You can only deduct $3,000 a year of capital loss against active income.  But you can deduct an unlimited amount of capital loss carryover against capital gains.  So make sure you consider realizing some capital gain to offset against your suspended capital losses.  If you are holding appreciated stock that you could sell at a gain, but you want to retain such investment, consider selling the stock to realize the gain, and then repurchasing the stock.  The wash sale rules only apply to losses so you can sell and repurchase at the same price on the same day.  Give me a call or email at Jsenney@pselaw.com or 937-223-1130 if you want to talk about year-end tax planning.

Related Party Sale May Have Unexpected Results

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Sale, exchange or distribution of appreciated property between related parties can create certain adverse tax consequences for sellers including recharacterizing capital gains as ordinary income, denying installment sales reporting, disallowing realized losses and restricting the use of like-kind exchanges.

Gain on the sale of depreciable real property held for more than one year can be subject to three (3) different tax rates.  Depreciation recapture is taxed as ordinary income at a max rate of 35%.  Unrecaptured gain on depreciable real property is taxed at a max rate of 25%.   And long-term capital gain is taxed at the capital gain rate (currently at a max rate of 15%).

In addition, under Internal Revenue Code section 1239, gain that would otherwise be treated as capital gain is converted to ordinary income if the property was depreciable and was sold, exchanged or distributed between related parties. This rule applies to property that can be depreciated by the buyer, whether or not the seller could depreciate the property and whether or not the buyer chooses to depreciate the property.  The special rule of section 1239 does not apply to property such as raw land which is not depreciable.

When applying the depreciation recapture rules and the special rule of section 1239 to a related party sale, the seller first allocates the gain on sale of the property between the depreciable property and the non-depreciable property.  The seller then applies the depreciation recapture rules to the portion of the gain attributable to the depreciable property.  The remainder of the gain on the depreciable property if any is then treated as ordinary income under section 1239.

For purposes of section 1239, “related parties” include a taxpayer and all controlled entities.  In determining who are related parties, the constructive stock ownership rules apply.  Similar but different rules apply where the property is held by a partnership.  More about that in a future blog.  Please call or email me at 937-223-1130 or Jsenney@pselaw.com if you have any questions or comments.

AND ONE MORE THING.  The federal estate tax exemption in 2012 is $5,120,000.  The federal estate tax exemption is scheduled to return to $1,000,000 in 2013.  With this in mind, some people are gifting real estate and other appreciated assets to their children and grandchildren this year.   And to get even more bang for the buck, people are contributing these appreciated assets to an LLC or other closely-held company, and then gifting ownership interests in the LLC rather than gifting the appreciated asset itself.  The reason?  Valuation discounts of 30 to 40% can be taken when gifting a minority interest in an LLC rather than gifting the appreciated asset itself.   If you are interested in doing some end of year gifting, please give me a call.   Jsenney@pselaw.com or 937-223-1130