Businesses that chose to organize as a corporation do so for many reasons. Chief among these is to protect the owners and their assets from liability arising from the actions of the business or its employees. This is accomplished because a corporation is an “artificial person” in the eyes of the law – a legally separate entity from its owners.
Some owners, however, have trouble keeping personal expenses out of the corporate checking account. These personal expenses are non-deductible, and in many cases are classified as loans from the corporation to the owners, or as repayments of prior loans made to the corporation by the owners. A recent court case highlights the danger of this practice.
A couple took nearly $740,000 out of corporations they owned, and classified them as discussed above. The IRS determined, and the US Tax Court agreed, that they were, in fact, dividends to the owners, and were fully taxable to the owners on their individual tax returns.
How do you help prevent this type of problem from occurring in your business? Below is a list of the factors the tax court considered in its decision – use these as a guide.
- Document the intention to make a loan, and the intention to pay it back
- Treat the loan like a loan- record the loan advances, calculate interest at a reasonable rate, have a repayment schedule.
- Create a promissory note for all loans
- Note that the loan advances and repayments are just that
- Be sure the amount of money borrowed and loaned is not excessive given the financial position of the owners and the business.