In order to conduct or expand their business operations, a construction company (like other closely held companies) may have to obtain cash advances from the company shareholders.  The federal income tax treatment of those cash advances is subject to particular scrutiny as the IRS could argue that the advances should have been treated as an equity contribution from the shareholders rather than loans. 

Why is this distinction important to the company (and to the IRS)?  Because federal income tax law treats debt and equity differently.  Primarily, interest payments by the company on debt are deductible by the company, while dividend payments by the company on equity contributions are not deductible.

 Whether a corporate investment is, for tax purposes, a loan by the shareholders or an equity contribution is a difficult question with no clear statutory answers or clear answers provided by the Treasury Regulations.  To determine whether a shareholder advance to a closely held company is debt or equity, a court will look at these factors:

            Fixed Rate of Interest and Interest Payments:  A court will first look at whether or not a fixed rate of interest and regular interest payments were made in connection with the shareholder advances.  Their absence indicates equity; while the presence of both evidences that the shareholder advances were bona fide loans.  However, paying excessively high interest rates to the shareholders might indicate a distribution of corporate profits to the shareholders is being disguised as debt payments.  It is important to consider what interest rate would be available from a bank or other outside lending source for the same type of loan.

            Written Instruments of Indebtedness:  The presence of promissory notes or other written evidence of indebtedness (such as a written line of credit agreement) is a strong indication that the shareholder advances are loans and not equity contributions. 

            Fixed Maturity Date and Schedule of Payments:  The absence of a fixed maturity date and a fixed obligation to repay the advance amounts indicates that the advances were capital contributions and not loans.  Frequently, advances are structured as demand loans with ascertainable maturity dates controlled by the shareholders.  Where advances are documented by demand notes with a fixed rate of interest and regular interest payments, the lack of a maturity date and a schedule of principal payments does not strongly favor equity treatment versus loan treatment. 

            Source of Repayments:  Statements should be avoided in the corporate records that the source of funds to repay the advance will come from company profits, since this implies that repayment is tied to the company's fortunes, suggesting that the advances were equity contributions.  It should be emphasized that repayment could come from other sources, such as liquidation of assets or refinancing with another lender.

            Use of Advanced Funds:  Use of advances to meet the daily operating needs of the company (i.e., to provide working capital) rather than to purchase capital assets, is indicative of bona fide debt.  Consequently, going to a bank or other outside lending source to obtain the funds necessary to buy equipment and other capital assets will help the company preserve the desired debt treatment of the shareholder advances.

            Sinking Fund:  The fa/ilure to establish a sinking fund (a type of reserve considered to be a form of security for debt) for repayment is considered to be evidence that the shareholder advances were intended to be equity contributions rather than loans.  However, where a company has sound capitalization and there are outside lending sources ready to loan it money, there is less need for a sinking fund.

            Security:  The lack of collateral to secure repayment of a shareholder advance is an indication that the advance was intended to be an equity contribution rather than a loan.  Consequently, if possible, collateral should be provided by the company (and documented) to secure the company's repayment obligations to the shareholder.

            Availability of External Financing:  The fact that the company has previously obtained, or is able to obtain, financing from a bank or other outside financing sources is also a factor.  If no reasonable lender would have acted in the same manner as the shareholder in making an advance to the company, the evidence becomes stronger that the shareholder advance is a capital contribution rather than a loan.

            Capitalization:  The adequacy of a corporation's capitalization is also a factor in determining whether a corporation will be successful in arguing that a shareholder advance is a loan rather than an equity contribution.  Inadequate capitalization is strong evidence that the advances are capital contributions rather than loans.

            Proportions of Advances vs. Stock Holdings:  Determining the extent to which advances by shareholders are proportional to the ownership interests of the shareholders in the corporation is an important factor.  If advances are made by shareholders in proportion to their respective stock ownership, an equity contribution is indicated rather than bona fide debt.

            Subordination to Other Creditors:  The extent to which the shareholder advances are subordinated to claims of outside lending sources is also a factor to be considered.  Subordination of advances to the claims of all outside lending sources indicates that the advances were capital contributions and not loans.

 No one factor is controlling or decisive, and much depends on the particular circumstances of each case.  In essence, the more a shareholder advance resembles an arms-length transaction, the more likely it is to be treated as debt for interest expense deduction purposes.

Kimbal Gowland is a partner with the law firm Meuleman Mollerup LLP, practicing in the areas of real property law and general business law.  Mr. Gowland brings to his law practice years of business experience plus the additional qualification of Certified Public Accountant.  Mr. Gowland can be reached at 208.342.6066 or This e-mail address is being protected from spam bots, you need JavaScript enabled to view it .  More information is available at www.lawidaho.com