Contractors are asked or required to put additional paid-in capital back into their businesses more frequently than any other business type. Most of these requests come from banks and bonding companies to provide assurances on the contractor’s lending and bonding capacity. This funding of working capital often comes from the contractor’s personal savings or equity borrowed from their home.
What gets contractors into trouble with the IRS is a lack of documentation and support for how to account for these transactions, especially when the intent is for the company to pay back its owners. Without proper documentation of the intentions of the transactions, the IRS could view these loan repayments as wage income – which could have unintended tax implications.
Here are some common pitfalls to avoid and ways to structure this type of transaction to avoid scrutiny with the IRS.
Begin With The End In Mind
When a contractor is asked to fund additional capital back into the business, he or she often complies without understanding the full business and tax consequences of the transaction. There is usually some urgency in the matter and the funds may be easily available to the contractor through a simple wire transfer from their personal funds to the business bank account. This is a mistake, and the IRS will often attack this point first when scrutinizing the transaction.
Therefore, the best defense is beginning with the end in mind. This means asking yourself at the time of the initial transfer whether you expect repayment of this money from the company in the future. If so, these intentions should be disclosed and documented by both parties as a loan when the transaction occurs. A common way to do this is to document it in the company’s annual corporate minutes.
If the intentions are not clear, the IRS will always view this transaction as a contribution of additional capital to the business, which could complicate how the money is repaid to the contractor.
Ensure You Have the Proper Documentation
Once you have established that the intention of the transaction is a loan, you must properly execute formal documentation. Inadequate documentation is another common mistake made by contractors.
You first need to establish an official note instrument between the two parties that shows a debtor/creditor relationship. This note should outline the repayment terms and include a stated interest rate that is reflective of the length of the note. If the company is limited on cash to repay the note, it may be best to structure it as an interest-only note with flexibility to repay principal at any given time in the future when funds are available. The note should have a time limit when the full amount will be due.
Without this documentation, the IRS will again have more basis to re-class the transaction as additional paid-in capital from the business owner. This would jeopardize the future loan repayments to the business owners as wage income, which could have unintended income and payroll tax consequences.
Respect the Transaction
Even if the items above have been established, the IRS can still scrutinize the transaction if the parties to the note instrument do not follow through on the execution of the document. We often see this as another fatal mistake contractors make.
The parties to the note instrument must follow through on the intention of the transaction. If the note calls for principal and interest payments to be made annually, then the business should make these payments annually to the business owner. If the repayment terms are not consistently followed, the IRS can make an argument that the company never had the intention to repay the money to the business owner. Again, the IRS could say that the loan repayment, once made, could be viewed as a form of compensation income to the business owner.
Business owners are often asked to provide additional funding to their businesses to support their growth. Most of the time, it is expected that the money will be repaid to the business owners at some point in future. Without following the specific guidelines discussed above, the IRS can attack this transaction and view it as a form of compensation to the owners when the money is repaid. Taking time in the beginning to thoughtfully structure and document the transaction goes a long way toward protecting your company and its owners from these unwanted tax consequences.
Carlo R. Ferri can be reached at Email or 215.441.4600.
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