Transactions between a closely held corporation and its shareholders are subject to scrutiny, and a recent case reminds us of the importance of proper documentation. In Knutsen-Rowell, Inc. v. Commissioner (March 16, 2011), the husband and wife who were the sole shareholders of two corporations removed funds from the corporations’ operating accounts to pay their personal expenses. These withdrawals were not reported as income on the taxpayers’ income tax returns. The IRS treated the distributions as dividends from the corporation and proposed a tax deficiency.

In the Tax Court, the taxpayers argued that the distributions were loans to themselves from the corporations. The court rejected this assertion because nothing had been done to document the distributions as loans. The court reviewed the criteria used to determine if a distribution is a loan: i) is there a written promissory note?; ii) is interest charged?; iii) is there a fixed schedule for repayment?; iv) was collateral given to secure the loan?; v) were payments actually made on the loan?; vi) did the borrower have a reasonable prospect of repaying the loan, and did the lender have sufficient funds to make the loan?; and vii) did the parties conduct themselves as if the transaction was a loan? In this case, none of these criteria was satisfied. The court found the distributions to be constructive dividends that should have been included in the taxpayers income.

Taking loans from a controlled corporation is risky at best. If you do it, it is critical that the loan be carefully documented, and that the criteria listed above be followed. The IRS takes a dim view of taxpayers extracting money from closely held corporations without paying tax on the withdrawn funds. In this case, the IRS asserted the 75% civil fraud penalty against the taxpayers. The court did not impose the fraud penalty but did impose the 20% accuracy penalty. The IRS only asserts the civil fraud penalty in cases it considers to be egregious. This was apparently one of those cases.