We have probably already had this discussion, if you are a client of Hodgson CPA who has a wholly-owned corporation. It is quite common for an owner/shareholder to dip into his/her own pocket to pay business expenses or put cash in the business bank account to cover payroll or other expenses. These transactions are recorded in the books to give the owner credit for his contributions or loans - there is nothing wrong with that.
The problem arises when the owner takes cash out of the company - a distribution - considering it a repayment of money he loaned the company earlier or considering it a loan from the company. Seemingly harmless, it may be as simple as an ATM cash withdrawal or use of the company debit card at a grocery store. Again, there is nothing wrong with that - as long as the loan has been properly documented. The IRS has rejected such draws as repayment of loans or new loans because the loans were not properly documented or formalized. The IRS may call them dividends, taxable as income to the shareholder.
In one such case the Tax Court ruled that Taxpayers failed to establish a debtor/creditor relationship using the following factors (Welch v. Comm, 85 AFTR 2d 2000-1064 (9th Cir.2000)): 1. a note or other instrument, 2. charging interest, 3. a fixed schedule of repayment, 4. collateral, 5. repayments actually made, 6. a reasonable prospect of repayment and 7. parties conducted themselves as if the transaction was a loan.
The lesson to be learned is to treat your business like a business not a piggy bank. Start writting notes for all loans between the owner and the corporation. At Hodgson CPA we would be glad to help you draft those notes. One simple step to avoid taxes.
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