What is a Bona Fide Loan for Tax Purposes? – Houston Tax Attorneys

It is often said that a taxpayer is free to structure their affairs as they see fit and can even do so in a way to minimize or avoid paying taxes. While this is true, it is equally true that the IRS is not bound by the taxpayer’s characterization of transactions. The IRS has a number of theories, arguments, and legal tools that it can use to recharacterize and, in some cases, even reverse the taxpayer’s characterization of transactions or even ignore the legal entity altogether.

There are several different recurring fact patterns where we see this. Intercompany transactions are prime examples. Loans are particularly suspect in terms of intercompany transactions and are frequently at the heart of tax disputes with the IRS.

This begs the question: what constitutes a bona fide loan for federal income tax purposes? The recent Feathers v. Commissioner, T.C. Memo. 2024-88, provides an opportunity to consider this question.

Facts & Procedural History

This case involves an S corporation that was organized to find and secure loans. The S corporation, in turn, owned other legal entities that were tasked with making the loans. The lower-level entities were to pay fees to the S corporation for finding loans that were funded.

The individual owner of the S corporation is the taxpayer in this court case. He caused the funds to transfer money to the S corporation and then took out some of the funds from the S corporation for his personal use.

The taxpayer took steps to document that these transfers were loans from the lower-level entities to the S corporation.

The SEC conducted an investigation, which led to criminal charges for financial crimes. After the taxpayer served time in prison, the IRS resumed its audit. It conducted a bank deposit analysis and determined that the loans from the lower-level entities to the S corporation were not loans, but rather commissions.

The IRS issued a statutory notice of deficiency on this basis and closed its audit. The case then ended up in the U.S. Tax Court.

About S Corporations & Flow-Through Taxation

An S corporation is a corporation or LLC that files a Form 2553 to make an election.

Once the S corporation election is made, the S corporation files a Form 1120S to compute the flow-through items, but those items are then picked up on individual shareholder returns and subject to tax on personal shareholder returns. This is done by issuing a Schedule K-1 from the S corporation to the shareholders of the S corporation. As explained below, the income flows through even if distributions are not made to the shareholder.

In addition to having tax at the shareholder level and not the entity level, the S corporation is also used to avoid self-employment taxes. That is beyond the scope of this article, but you can read about self-employment taxes for S corporations here.

Flow-through entities owned by an S corporation are reported on the Form 1120S. They add to the items of income and expense that get reported on the Schedule K-1 that is issued by the lower-level entities to the S corporation. The combined amounts from these lower-level entities and the S corporation itself all end up on the individual S corporation shareholder’s personal income tax return.

Tax Treatment of Intercompany Loans

An intercompany loan between flow-through entities generally doesn’t trigger income tax at the federal level. The entity that receives the loan pays interest back to the entity that made the loan and may get an interest deduction for tax purposes. The entity that made the loan picks up the interest income when payments are received. While it does not appear to be at issue in this case, taxpayers do often structure loans with S corporations to increase their basis to allow tax losses from the entity to flow through to the shareholder’s individual income tax return. You can read about S corp loans for losses, here.

Absent being a loan, in a situation like this where a subsidiary lends money to a parent entity, the amounts may also be taxed as distributions of earnings and profits. This too would normally not trigger income taxes. The earnings and profits of flow-through entities are picked up as income for the parent entity regardless of whether distributions are made from the subsidiary. If distributions happen to be made, they are usually tax-free to the extent of the parent’s investment (i.e., tax basis) in the subsidiary. Amounts in excess of this are often treated as capital gain on the sale of the parent’s interest in the subsidiary. Note, there is an exception for distributions of appreciated property, which can trigger a tax.

Alternatively, as argued by the IRS in this case, the transfers could also be compensation or commissions for services rendered by the parent for the subsidiaries. With this scenario, the commissions would be picked up as taxable income by the S corporation parent and that income would flow through to the S corporation shareholders. However, the subsidiaries would also get a corresponding tax deduction for the amount of the commissions made. The tax deduction would also flow through to the S corporation return and eventually to the shareholder’s individual income tax returns.

It is not clear from the court opinion, but it appears that the reason why the taxpayer was taking the amounts as loans was (1) to be consistent with his original treatment with the SEC and (2) that he did not own 100% of the S corporation or the lower-level entities. Thus, if the payments were commissions as the IRS argued, and not loans, the S corporation would pick up 100% of the amounts the S corporation received, but it would only get a portion of the offsetting tax deduction that also flowed through from the S corporations for the payment of the commissions. It seems that the lower-level entities may have had outside investors who owned those entities, which would produce a tax deduction for those other investors.

What is a Bona Fide Loan?

This brings us to the central question in this case: What exactly is a bona fide loan? The factors that the courts consider vary based on the leading court cases in the various circuit courts. The U.S. Tax Court sets out the factors in this court case as stated by the Ninth Circuit Court of Appeals.

The Ninth Circuit Court has said that whether a transaction was a bona fide loan is determined by considering these factors:

whether the promise to repay is evidenced by a note or other instrument;

whether interest was charged;

whether a fixed schedule for repayments was established;

whether collateral was given to secure payment;

whether repayments were made;

whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and

whether the parties conducted themselves as if the transaction were a loan.

In this case, the tax court determined that the transfers were not loans. Given the documentation and evidence, the tax court found that most of these factors were not satisfied. According to the court, the notes were executed after the transfers occurred, there was no evidence of interest being charged or paid, no fixed repayment schedule was established, and there was no collateral. Furthermore, the tax court found that the borrower entity did not have a reasonable prospect of repaying the purported loans given its financial condition. The court did not say whether there was a personal guarantee for the loan by the shareholder, which might have helped with this last factor.

For those seeking to have an intercompany transaction characterized as a loan, these are the exact findings that one would want to try to avoid.

The Takeaway

This case demonstrates the importance of carefully documenting intercompany transactions–particularly if the parties want the transaction to be respected as a bona fide loan. This is true even if the transactions are with flow-through entities and the amounts may seem like they net out on the shareholder’s individual income tax return. There are common fact patterns, like this one, where not all of the offsetting tax deductions land on the same shareholder’s income tax returns. This can trigger tax for the shareholder if the IRS were to recharacterize the loan as a commission payment, as it did in this case.