As far as the person writing the check is concerned, there is no distinction between a loan and investment, even if the contributor is also the owner. But from a legal perspective, there is a big difference.
Some contrasts are at the front end. Owner loans, like any other loans, must be independently documented. This documentation must include specifics like repayment schedules and the consequences of nonpayment. Investment funds must go into separate accounts, and owner draws must be noted as such on the company’s balance sheet.
There are some back-end differences as well. If the company declares bankruptcy, lenders might get their money back, especially if the loans were secured. Investors, however, are probably out of luck.
Not all business contribution transactions are clearly loans or clearly investments. So, 2011’s Ramig v. Commissioner listed ten factors to use in making this determination.
Borrower’s (Company’s) Ability to Borrow Money Elsewhere
If the company is well-established with a good credit rating, it probably could go to a bank or other commercial lender and borrow money. If that is the case and the investment/loan paperwork is fuzzy, the Tax Court may consider the transaction as a loan.
Source of Repayment
Loan repayment funds usually come out of a general count, and investor dividend funds usually come from a dividend account. That’s not always the case, but exceptions are rare.
Shareholder dividends are almost always in proportion to ownership interest. That’s especially true if paperwork is sparse because, in most states, proportionality is the default provision. If the transfer was not in proportion with ownership percentage, the transaction was probably a loan repayment.
Amount of Capitalization
Was the borrower’s repayment in line with its current capitalization? This factor is closely intertwined with proportionality, which was discussed above.
This factor is probably one of the most important ones. If the transfer agreement says “this transaction is a loan,” courts will probably interpret it as such, even if the document does not meet the other legal requirements. Phrases like this one are especially important if the state still uses the four corners rule. This doctrine bars interpretative evidence that is not inside the “four corners” of the instrument.
Contributor’s Priority Right
In some agreements, but not many, the lender (or investor) takes priority over other creditors in the event of bankruptcy. Truthfully, if the agreement contains a specific clause like this, it is probably a loan agreement on its face.
Contributor’s Management Rights
Typically, stockholders may attend meetings and make recommendations, but they have no management rights.
Contributor’s Right to Enforce Payment
This clause is usually a dead giveaway for a loan. Shareholder agreements simply do not have these kinds of provisions.
Stockholder investments normally do not mature. Generally, only loans mature.
Statement of Loan or Investment
The surprising thing about this factor is that it is listed at all. Even if the paperwork says “investment,” the transaction could still be a loan, depending on the other facts of the matter.
Whether you need to loan money to your new company or invest in it, contact a tax planning professional.
As a Certified Tax Coach, our advanced training is designed to lower your taxes and increase your wealth. Request your free consultation today by calling us at 903-793-0042. As a thank you gift for scheduling your consultation, we’ll provide a free book, Writeoffs to the Rescue.