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.