When Is A Loan Not A Loan?

With the sweeping new tax legislation in 2018 capturing everyone’s attention, other changes have taken a back seat. There were several Tax Court cases in 2018 that rendered important decisions impacting how things work – one of which was Povolny Group, Inc. v. Commissioner, T.C. Memo 2018-37.

The Povolny Group decision centers on a common issue where an individual uses his corporation like a personal pocketbook, transferring money in and out without any formality.

Facts of the Case

James Povolny joined his spouses’ company (LLC) as a minority owner. Later in 2002, he went out and started his own real-estate brokerage firm, the Povolny Group (PG), as a 100 percent owner.

At one point, PG won the bid to build a hospital for the Algerian Ministry of Health. To perform the job, Povolny formed another company as the sole owner: Archetone International (AI). To secure the contract, the government mandated guaranties and collateral. To meet this obligation, Povolny had AI, PG and LLC borrow money from lenders.

Unfortunately, the Algerian government quit paying Povolny and terminated the project. In the end, Povolny had a lot of debt and AI couldn’t pay it so he used LLC to pay $241k of AI’s debt, with LLC claiming a deduction for bad debt for tax purposes.

Later, Povolny used PG to pay $70k of the debt for both LLC and AI, with PG deducting these amounts as cost of goods sold. Eventually, when he was audited, Povolny changed his position claiming the amounts were really loans from PG to the other two companies.

IRS Position 

The IRS denied LLC’s $241k deduction for bad debt, claiming that the amounts were capital contributions and not loans and therefore could not be deducted as bad debt. The IRS also denied PG’s $70k deduction again on the premise that it was not a loan, but a capital contribution.

Relevant Law for Business Owners

If an individual owns 100 percent of a company or group of companies, they often treat business transactions informally because they view it as all their own money – taking cash in and out of the business without any formal process. This is something that could never happen if the business had multiple owners.

Example and Why It Matters

This often results in midstream changes in how the owner treats the transactions for accounting purposes. One example is where a business owner takes cash out and later discovers that these distributions exceeded their stock basis. This should result in a capital gain, but due to the informality of the transactions the shareholder changes how they treat the cash withdrawal from a distribution to a loan.

Another example of what frequently happens is there is a shareholder who puts money in a corporation, either themselves or through another entity they own, without any formal designation and then later accounts for it as a loan instead of a capital contribution.

What Really Matters

The rules are that you can only claim a bad debt deduction if there’s been a loan. Problems stem from the informality of the treatment between the individual and the entities they control; the IRS wants these types of dealings to be treated like arms-length transactions to validate the treatment and classification as either debt or equity.

Generally, there are 11 factors the IRS considers – all of which focus on how the transaction is structured and documents to see if it acts more like a real loan from a third-party lender or more like a capital contribution from the owner.

Conclusion

In the end, the court sided with the IRS and disallowed all of the deductions. The lesson here is that if you or a company you own advance money to another company and you want it to be considered a loan, then you need to treat it as a loan. Make sure you use a formal note with a stated maturity date, post collateral, pay interest, and record it as a loan on the tax return. If you want to write off debt as bad debt, you need to prove that you’ve done everything possible to collect and that repayment isn’t possible.

At the end of the day, the IRS doesn’t care if you own it all. But they do expect you to treat each entity you own as a separate entity rather than extensions of each other, making sure that everything is documented and treated with the appropriate formalities.