When a shareholder makes a “loan” to a corporation but the money is really an equity investment, the IRS often recharacterizes the debt as equity. That matters because:
- Interest on debt is deductible by the corporation and taxed to the lender only once.
- Dividends on equity are not deductible and are taxed twice.
Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076 (1972), is a classic case on this issue. Mr. Jemison caused a new corporation to be formed that bought the stock of an existing company. The new corporation was thinly capitalized – only 600,000 of notes to the sellers, which Jemison personally guaranteed.
The Fifth Circuit listed eleven factors for debt‑equity analysis, including the names given to the instruments, whether there was a fixed maturity date, the source of payments, the right to enforce payment, participation in management, and the ability to obtain outside loans. Applying those factors, the court held that the notes were equity, not debt. The guarantee enabled Jemison to put “his money ‘at the risk of the business’” without making an immediate cash investment. Id. at 720.
What’s the lesson? If you’re going to lend money to your own corporation, do it right – set a fixed maturity date, charge a market interest rate, and treat it like a real loan. Otherwise, the IRS may recharacterize it and disallow your interest deductions.This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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