Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
2) The corporation is treated as having received a like amount of interest income. 3) After the 1990 year, the shareholder will be allowed a deduction for the interest deemed paid to the corporation only if the shareholder can demonstrate the expense is other than a personal expense. If the corporate loan is made to an employee, who is unrelated to the shareholder as discussed in IRC section 267(c), the scenario is similar except: 1) The foregone interest is characterized as additional compensation to the employee. 2) The corporation has deemed interest income in a like amount. 3) The corporation can deduct the amount as compensation, subject to reasonable compensation limits. IRC section 7872(f)(9) specifically states that the amount of additional compensation flowing to an employee from a compensation-related below-market loan is not subject to income tax withholding. Such compensation is subject to FICA and FUTA employment taxes (Conference Committee Report on P.L. 98-369). Even though income tax withholding is not required, payments must be reported under the appropriate information provision. 4) After the 1990 year, the employee will only be allowed a deduction for the interest deemed paid to the corporation if the employee can demonstrate the expense is not a personal expense. When a below-market interest rate loan is made between otherwise related entities, or a shareholder makes a loan to his or her corporation, the adjustments resulting after imputing the interest are: 1) The shareholder receives interest income in the amount of the foregone interest. 2) The corporation has deemed interest expense in a like amount. 3) The foregone interest will treated as a capital contribution by the shareholder. See Treas. Reg. section 1.7872-4(d) (Proposed). Although the transfer of taxable income between parties may appear to be offsetting, there can be significant tax impact in the reallocation, depending on the relative tax brackets of the borrower and lender and the deductibility of the interest deemed paid. The regulations contain detailed instructions for computing the interest imputed on interest free and below-market rate loans using published federal rates. A simplified method is available for use in imputing interest on loans of $250,000 or less. Rev. Rul. 86-17 provides for the use of a "blended annual rate" to simplify the computation of the amount of foregone interest. There is no threshold dollar amount. B-8
Despite the fact the computation may seem somewhat tedious at first, adjustments can be substantial and are required by law. b. Thin Capitalization Upon reviewing the loans from shareholder and the common stock accounts, a thin capitalization issue may exist. Thin capitalization may be at issue where there is little or no common stock and there is a large loan from the shareholder. IRC section 385 was enacted for the purposes of determining whether an interest in a corporation is to be treated as stock or indebtedness. Under this code section, there are five factors which need to be considered. In addition, the agent should consider relevant court cases. The objective concerning a thin capitalization issue is to convert a portion, if not all, of the loans from the shareholder to capital stock. By performing this conversion, an adjustment to the interest expense will be necessary because the loans at this point will be considered non existent. The interest paid by the corporation, which has been disallowed by the examiner, will now be classified as a dividend at the shareholder level to the extent of earnings and profits. The courts have not always supported the government’s pursuit of this issue as shown in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968). This opinion considered equity to be high risk. Monies loaned are considered low risk. Thus, to loan money to one’s corporation is in effect limiting their risk because equity is only allowed a capital loss, but loans can be afforded the benefit of being classified as ordinary losses under IRC section 166. In addition, the court stated a shareholder would not loan their corporation money at extraordinary rates because this would be self-defeating as it would damage their own corporation. If this issue is present the adjustments would be: 1) Increase to the common stock account. 2) Decrease to the loans from shareholder account. 3) Disallowance of a portion of the interest expense. 4) Reclassification of the interest income at the shareholder level to a constructive dividend. 5) The repayment of debt would be recharacterized as a redemption of stock and may be a dividend. 5. Building and Equipment In an auto dealership, it is common for the dealership to rent the land and building from a related entity. Where this occurs, building and equipment will not be one of the larger balance B-9
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Despite the fact the computation may seem somewhat tedious at first, adjustments can be<br />
substantial and are required by law.<br />
b. Thin Capitalization<br />
Upon reviewing the loans from shareholder and the common stock accounts, a thin<br />
capitalization issue may exist. Thin capitalization may be at issue where there is little or<br />
no common stock and there is a large loan from the shareholder. IRC section 385 was<br />
enacted for the purposes of determining whether an interest in a corporation is to be<br />
treated as stock or indebtedness. Under this code section, there are five factors which<br />
need to be considered. In addition, the agent should consider relevant court cases.<br />
The objective concerning a thin capitalization issue is to convert a portion, if not all, of the<br />
loans from the shareholder to capital stock. By performing this conversion, an adjustment<br />
to the interest expense will be necessary because the loans at this point will be considered<br />
non existent. The interest paid by the corporation, which has been disallowed by the<br />
examiner, will now be classified as a dividend at the shareholder level to the extent of<br />
earnings and profits.<br />
The courts have not always supported the government’s pursuit of this issue as shown in<br />
Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968). This opinion<br />
considered equity to be high risk. Monies loaned are considered low risk. Thus, to loan<br />
money to one’s corporation is in effect limiting their risk because equity is only allowed a<br />
capital loss, but loans can be afforded the benefit of being classified as ordinary losses<br />
under IRC section 166. In addition, the court stated a shareholder would not loan their<br />
corporation money at extraordinary rates because this would be self-defeating as it would<br />
damage their own corporation.<br />
If this issue is present the adjustments would be:<br />
1) Increase to the common stock account.<br />
2) Decrease to the loans from shareholder account.<br />
3) Disallowance of a portion of the interest expense.<br />
4) Reclassification of the interest income at the shareholder level to a constructive<br />
dividend.<br />
5) The repayment of debt would be recharacterized as a redemption of stock and may be<br />
a dividend.<br />
5. Building and Equipment<br />
In an auto dealership, it is common for the dealership to rent the land and building from a<br />
related entity. Where this occurs, building and equipment will not be one of the larger balance<br />
B-9
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