Even though no dividend has been
declared, IRS has the ability to treat withdrawals of cash from the
corporation, and other transactions, as dividends, if they aren't handled
properly. Although dividends are now taxable to noncorporate
shareholders at capital gains rates, the tax can be avoided with a little
planning. A Tax Court case demonstrates what can happen when a shareholder
isn't careful and treats a corporation he or she controls as though it were, in
effect, a personal bank account.
In that case, a husband and wife
owned the corporation. The husband, John, ran the corporation, and dealt with
it very informally. He took money out as needed for personal expenses, and
received a $100 check along with each weekly paycheck. John and the corporation
accounted for these withdrawals as “shareholder advances,” and both John and
the corporation showed these advances as loans on financial statements that
were given to third parties. At the end of every year, part of the outstanding
balance of the shareholder advances account was repaid by crediting John's
year-end bonuses against it.
Nevertheless, on audit IRS
determined that the shareholder advances weren't true loans, and treated them
as dividends. The Tax Court agreed with IRS. John argued that the casual way in
which he and the corporation handled the advances shouldn't be held against him
because all of his dealings with the corporation were informal. The court
wasn't impressed by this or by John's other arguments, and wanted proof that
John intended to repay the advances, and that the corporation intended to
require repayment.
There are about a dozen factors
that the courts look at to decide if a shareholder withdrawal is a loan or a
dividend. Most of these are within your control. One important factor, for
example, is whether there is a written promissory note. It isn't necessary that
each of the factors point to a loan, but taken
together they must be sufficient to establish that the withdrawal is not a
dividend.
Please call our firm if you have
any questions.