The IRS has the power to recharacterize a related-party transaction.
Incorporated but closely held veterinary practices along with their principals/shareholders routinely—and legally—advance money to each other. This can take the form of cash or take the form of paying each other's debts or obligations. Although contributions made to an incorporated practice are generally tax-free, there can be other tax consequences.
All too often, the veterinary practice, the shareholder and their tax advisors ignore the routine shuffling of cash between the veterinary practice and its shareholders/principals. Unfortunately, the ever-vigilant Internal Revenue Service rarely does.
Prior to enactment of the lower, and temporary, tax rates for dividends, the IRS often targets incorporated businesses by demanding that a portion of the operation's profits be distributed as dividends rather than as compensation. Excessive compensation, in the IRS' eyes at least, indicates that the principal/shareholder was attempting to avoid the double-tax due on dividend income—taxed once at the corporate level and taxed again as the personal income of the recipient.
Today, however, the IRS appears to be focusing its attention on the tax consequences of related-party transactions, especially so-called "cross-loans" and other "below-market" loans that occur between a corporation and any of its shareholders.
Generally, when a shareholder advances money to the corporation he or she controls, it is considered to be a contribution to capital with no tax consequences. Many other transfers, as well as loans between a shareholder and his or her incorporated veterinary practice, should call for interest payments. Interest payments that are deductible by the borrower must be reported as income by the lender. A low or non-existent rate of interest on the transaction means, of course, that one party has a smaller tax bill.
Since a veterinary practice or business troubled enough to require an infusion of cash from its shareholders is unlikely to need another tax deduction, interest payments often are ignored or stated at a very low rate. In any transaction between related parties, including family members, a partner and his or her partnership, or a veterinarian and his or her incorporated practice, it is a related-party transaction unless it qualifies as arm's length. With any transaction that is not at arm's length, the IRS has the power to recharacterize it. That means interest income, at a rate that the IRS deems fair, must be paid retroactively to the lender and credited to the borrower. These retroactive hits on the lender can result in a substantial tax bill.
There are tax consequences for all so-called below-market loans between a corporation and any of its shareholders even in situations where both advances and repayments occur at the same time. Consider a situation revealed in a recent, non-binding decision by the U.S. Tax Court involving the cross-loans between ATV, an incorporated business with substantial gross sales, and its owner/shareholder.
Paul Revere, who owned 45 percent of the shares, founded the business. During 1997, ATV and Paul Revere had open-account indebtedness running back and forth between them with no provisions for interest. At all times during 1997, Revere's debt to ATV exceeded its debt to him.
Advances to him were the result of personal items he purchased with his corporate credit card, as well as child-support payments made on his behalf by the corporation. Revere owned the ATV headquarters building, and the main advance from him to the corporation consisted of the monthly rent on that space, net of mortgage payments made by ATV on his behalf.
Congress created some rather esoteric concepts in attempting to eliminate the tax-avoidance problems inherent in below-market interest situations. One 1984 law change was the addition of Section 7872 to the tax law to deal with gift loans, demand loans and other below-market loans. Section 7872, "Below Market Rate Loans," did more than merely impute interest; it also provided a framework for doing something else with the foregone interest in corporate loans to shareholders.
As explained by a Tax Court judge, under Section 7872, the foregone interest on a loan by a corporation to its shareholders is treated as a distribution to the shareholder and generally taxed as a dividend. The foregone interest on a loan by a shareholder to a corporation is treated as a capital contribution. In other words, if the imputed interest is calculated gross, then the adverse current income tax consequences to the shareholder under Section 7872 get maximized.
When different methods of accounting are used by related taxpayers, accrued interest and expenses owed to a related taxpayer may not be deducted until the time that the interest or expense payment is includable in the gross income of the cash-basis payee. Thus, an accrual-basis payer is placed on the cash basis for the purpose of deducting business expenses and interest owed to a related cash-basis taxpayer. The deduction is deferred until the cash-basis payee takes the item into income.
The related taxpayers covered by this rule include certain family members, members of a controlled group of corporations, controlling shareholders and controlled corporations, as well as owners of pass-through entities, such as a partnership and its partners or an S corporation and its shareholders.
A personal services corporation may not deduct payments made to owner-employees before the tax year in which such person must include the payment in his or her gross income. For this purpose, a personal service corporation and any employee-shareholder are considered related.
The IRS generally recharacterizes loans between a veterinary practice and its principal/shareholder that are ignored or that carry little or no interest as arm's-length transactions. That's right, the IRS has the power to retroactively treat the transaction as an arm's-length transaction, which treats the lender as having made a loan to the practice bearing the stated federal rate of interest.
When it occurs, the related-party transaction is deemed to be a transfer in the form of a gift, dividend, contribution to capital, compensation or other manner of payment (depending upon the nature of the loans) from the lender to the borrower which, in turn, is retransferred by the borrower to the lender to satisfy the accruing interest.
This rule applies to all gift loans, corporation-shareholder loans, compensation loans between an employer and employee or between independent contractors and clients, tax-avoidance loans, any below-market interest loans in which an interest arrangement has a significant effect on either the lender's or the borrower's tax liability, and loans to any qualifying continuing care facility not exempt under the rules.
Fortunately, a de minimis exception applies to gift loans totaling $10,000 or less between individuals as long as the loan is not directly attributable to the purchase or carrying of income-producing assets. There is also a $10,000 de minimis exception for compensation-related or corporation-shareholder loans that do not have tax avoidance as a principal purpose.
Generally, a related-party transaction is considered to be arm's length as long as the stated principal amount is less than the amount that must be repaid. The tax rules (Section 483) kick-in only when there is inadequate or unstated interest. Under the tax rules, related-party transactions where the amount borrowed is the same as the amount to be repaid require unstated interest be determined using an interest rate equal to the applicable federal rate.
The Applicable Federal Rate (AFR) is determined by the IRS using the federal short-term, mid-term and long-term rates for every calendar month based on average market yields of specified maturities.
It is broken down in this manner:
If the principal in a veterinary practice gets stuck after lending money to his or her business, it's usually treated as a nonbusiness bad debt, deductible against capital gains. Or, up to $3,000 may be deducted against ordinary income in any one year. However, if the loss is a business bad debt, the amount is fully deductible.
A veterinarian might be able to claim a business bad debt if the money was loaned to the practice in an effort to preserve their employment. That's right, loans made to maintain employment are considered to have been made in the trade or business of the employee—even the employee/principal of a veterinary practice. The deduction usually is taken as a miscellaneous itemized deduction on Schedule A of the lender's personal tax return subject to the 2 percent floor of personal itemized deductions.
With the IRS having the legal power to recharacterize related-party transactions whenever warranted, it frequently does it on its terms. Obviously, it will pay every veterinarian to get those pocket-to-pocket, principal-to-practice and practice-to-principal transactions accounted for correctly before the IRS does it for them.