Debt or Equity? IRS Rules for Shareholder Loans

Consider a common scenario. A founder lends $2 million to his company, and the board approves the money as a loan.

Everyone treats it as a loan. Three years later, the business fails.

The founder claims a bad debt deduction. The Internal Revenue Service says the money was equity from the beginning.

Nothing about the payment changed. Only its tax label changed.

The label depends on the deal’s real economic meaning. In simple terms, the IRS asks whether repayment was truly required.

The same question arises whenever money moves between a business and the people or companies that own it. The answer determines what each side may deduct and how each side reports the advance on its tax return.

Why does the label matter?

The label affects the taxes of both the company and the lender. It matters while the business is running, and again if it fails.

Sources: [4, 5, 6, 7]

For individuals, capital losses come with an annual limit. Once any capital gains are used up, only $3,000 a year can be deducted against other income, or $1,500 if married filing separately [8].

The rest carries forward to later years [9]. For a founder with a $2 million loss and no capital gains, that can mean using the loss only $3,000 at a time.

What does the IRS look for?

A board resolution and a signed note help, but they do not settle the question. The IRS is not bound by the company’s label and can look at how the arrangement actually worked [1].

The Tax Court has summarized the test this way:

In other words, did the parties genuinely intend a loan, and did the deal operate the way a real loan would? No single fact decides the answer [6].

Sources: [1, 3]

A case in point: Deja Vu, Inc. v. Commissioner

In Deja Vu, a company advanced money to a related business, Adult Fun, under unsecured notes carrying 10 percent interest. Adult Fun had virtually no assets, so repayment depended entirely on its business succeeding.

Adult Fun made no payments, and the lender did not pursue collection until Adult Fun had gone out of business. The court, which refers to the lender as “petitioner,” concluded:

The court also upheld an accuracy-related penalty against the lender [3]. A mislabeled advance can therefore cost more than the lost deduction.

What does this mean for tax reporting?

The label is not only a legal question. It decides what the company and the lender put on their tax returns.

If the IRS later decides the advance was equity, it can disallow those deductions on both sides. The result is additional tax and, as in Deja Vu, possible penalties.

If it is a real loan, can the lender deduct the full loss?

It depends on who the lender is and why the loan was made. A company that lends to a related company can generally deduct a worthless loan as a bad debt; the limits below apply only to lenders that are not corporations [5].

For an individual, such as a founder or shareholder, the answer is yes only if the loan is a business bad debt. Otherwise, the loss is subject to the capital loss limits [5].

Sources: [5, 8, 12, 13]

Which one applies depends on the main reason for the loan. Protecting a salary is a business reason; protecting the value of one’s shares is not.

The Supreme Court requires the business reason to be the main one. In Generes, a 44% owner with a $12,000 salary and $38,900 invested in stock could not show that protecting his salary was his main reason, so his loss was not a business bad debt [12].

What should be in place when the money is advanced?

The strongest evidence is created when the money changes hands. The IRS asks whether a loan was intended at the time of the transaction [11].

These records show what the deal actually was. They do not guarantee a tax result, because the outcome depends on all the facts [6].

This article is for informational purposes only and does not constitute legal or tax advice. Reading it does not create an attorney-client relationship with Dilendorf Law Firm. Attorney Advertising. Prior results do not guarantee a similar outcome.