You know how it is as the owner of a small business. Accounting and formalities are usually the last thing on your mind. Growing your customer base, dealing with employees, finding trustworthy vendors… Those are the things you worry about. So when a bill needs to get paid, you pay it out of whatever checkbook has money – the company’s, your personal, the real estate LLC’s – and figure the bean counters will sort it out later.
And the bean counters do sort it out. They tally up that over the years you have loaned the company $150,000 because bills needed to get paid in order to keep the company afloat and keep you employed. And the bean counters recommend that you write up a promissory note with fixed repayment terms and that you charge interest on the loan. But those are formalities, and you might have to get an attorney to do it, and those aren’t the types of things that grow your business, so you ignore the bean counters’ advice.
Then the unthinkable happens. The company loses its biggest customer and has to shut the doors. You’re never going to get your $150,000 back. It’s little consolation, but at least you’re going to get a $50,000 tax write-off for that $150,000 you loaned to the company. That’s what Juan Herrera thought, until the Tax Court told him he had to repay the $50,000 of tax because his write-off was really only $450/year for 50 years (Herrera will probably be dead before he can claim it all).
The Tax Court decided the case completely on the fact that the $150,000 was not a bona fide debt. Without a bona fide debt, there cannot be a bad debt deduction for the person who “loaned” the money. And if it doesn’t qualify as a bad debt deduction, it will be a capital loss that can only offset capital gains plus $3,000/year of ordinary income. How could Herrera have made this $150,000 a bona fide debt? He could have had a written promissory note with fixed repayment terms and charged interest. If only he had listened to the bean counters…
The IRS likes formalities, and when it doesn’t see those formalities being attended to, it tends to look more harshly on a taxpayer. One of the first things requested in every corporate audit is the corporate record book. This would be the bylaws, stock certificates, minutes of shareholder and directors’ meetings. They want to make sure you are really acting like a business. And part of acting like a business is having agreements with outside parties for things like loans and leases.
Without these formal agreements, or if the formal agreements are unreasonable and/or aren’t actually being followed, the IRS has broad powers to recharacterize transactions in a less tax-friendly way. All of a sudden that loan is really contributed capital, and the $5,000/month you get for leasing the building to the company is really a $2,000/month lease and a $3,000/month dividend (not deductible by the company). And since you didn’t turn in formal expense reports for your business meals or mileage logs for your company car, those things are now extra taxable compensation to you. If you don’t observe formalities, you shift the power to the IRS.
So next time your bean counter blathers on about getting your corporate records up-to-date, or writing up a promissory note, or tracking your business miles, just remember Juan Herrera. Remember how he couldn’t be bothered to write up a promissory note and charge some interest. And remember that he’ll probably be dead before he gets all his tax write-offs. Don’t be Juan Herrera.