Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

Once the existence of a shareholder loan is established, the concern is whether the loans are
arms length transactions (i.e. length of loan, interest rate, etc.). The shareholder could be
receiving an interest free loan or they may be taking money out of the company tax free,
through forgiveness of the loans by the corporation at a later date. Therefore, the examiner
should request copies of the loan documents. If loan documents exist, they will show the
terms which the examiner can then validate. If loan documents are not available, the examiner
should review the corporate minutes for a possible mention of and the details of the loans.
In regard to interest generated by a loan from shareholder, the examiner must inspect the
payables accounts for a possible deduction of the interest owed which the shareholder which
has not been paid. IRC section 267(a)(2) states the corporation and the shareholder (who
hold a greater than 50 percent interest in the company either directly or by attribution) will be
put on the same basis of accounting, usually cash basis, to determine when a deduction is
allowed, even though one is an accrual basis taxpayer and the other is cash basis. In simpler
terms, the corporation will be allowed a deduction when the interest is paid, not when it is
accrued. However if the corporation has accrued the expense, inspect the Schedule M-1 to
determine whether the amount has been backed out for tax purposes. To illustrate this point
consider the following example:
A corporate taxpayer has a tax year ending in June. The corporation accrued and
deducted $125,000 as interest expense which was related to a shareholder loan. The
corporation had only paid $75,000 before its yearend but paid the remaining $50,000
in December. Even though the shareholder is required to include the full $125,000 in
his calendar tax year, the corporation is not allowed a deduction for the accrual of
$50,000 until such time as it is paid. Timing adjustments, such as this, should be
considered and made.
a. Demand Loans
Often times, the loans between the taxpayer and its shareholder will be demand loans in
lieu of formal loans with a stated rate of interest and repayment period. In the case of
demand loans, special rules apply under IRC section 7872. IRC section 7872(f)(4) defines
a demand loan as "any loan which is payable in full at any time on the demand of the
lender" and is not necessarily "in lieu of formal loans." The foregone interest on such
below-market interest rate loans is treated as transferred from the lender to the borrower
as of the last day of the calendar year and retransferred immediately from the borrower to
the lender as interest. There is a $10,000 de minimis exception for compensation-related
and corporate-shareholder loans that do not have tax avoidance as one of the principal
purposes. See IRC section 7872(c)(3).
When a corporation makes interest free (or low interest) loans to its shareholders, the
shareholders’ family members, or other related parties the constructive ownership rules of
IRC section 267(c) apply per Treas. Reg. section 1.7872-4(d)(2)(ii).
1) The shareholder has received a constructive dividend in the amount of the foregone
interest to the extent of earnings and profits.
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