Shareholder Debt

Shareholder Debt

June 01, 2006

Shareholder debt passed muster in court.

Several members of the family that owns a small manufacturing company made advances to the company periodically to cover working capital requirements. These advances were eventually documented as loans. The company paid out 10% annual interest on them. There was no fixed maturity date when the loans had to be repaid and no formal repayment schedule. Repayment was subordinated to the obligation the company had to its outside bank to repay loans from it. The shareholders liked the arrangement because unlike most corporate earnings that are taxed twice— once to the corporation and again to the shareholders when the earnings are distributed as dividends — these earnings were taxed only once. The company deducted the earnings that were paid to the shareholders as interest. Only the shareholders paid tax on them.

The IRS disallowed the interest deductions arguing that the “loans” were really shareholder equity in the company.The company did not pay any dividends during the tax years in question. All the shareholders received from the company were the regular interest payments.

A US appeals court said the shareholder loans were real debt. The court released its decision in mid-April. The case is Indmar Products Co. v. Commissioner.

The court acknowledged that it is sometimes hard to draw lines between debt and equity, and said it uses a list of 11 factors when trying to decide which label to apply. However, it said the factors distill to a simple test that “the more a stockholder advance resembles an arm’s-length transaction, the more likely it is to be treated as debt.”

The court found helpful to debt classification in this case the fact that the loans bore a fixed rate of interest, and the rate was consistent with market rates at the time. It said lack of a maturity date or repayment schedule was not important since these were “demand loans” that were to be repaid upon demand of the persons making the loans. It was helpful that the funds were used for working capital needs rather than to purchase capital equipment. The court said the fact that the company paid no dividends during the period would only have been relevant if the shareholders were charging interest at exorbitant rates. They were not. Not all of the shareholders made loans, but all of the shareholders were members of the same extended family.

The total shareholder loans were less than half the net current assets of the company and only a small fraction of its annual gross receipts.

Indmar treated the advances as short-term debts for state tax purposes in order to avoid a 6% Tennessee tax on dividends and interest on long-term debts. However, it treated the amounts as long-term debts on its financial statements and reports to its outside bank. It justified the reporting position by getting annual waivers from the shareholders who made loans that they would forego repayment of the principal for at least another 12 months.

By Keith Martin