"Loans” from wholly owned corporations were unreported constructive distributions

The Tax Court has concluded that a husband and wife failed to report constructive distributions from their respective wholly owned corporations, rejecting their claim that these amounts represented shareholder loans. The taxpayers took funds from their corporations' operating accounts (via checks, withdrawals, and transfers) to pay their own and their children's living expenses.
RIA observation: This case is a reminder of how dangerous informality can be when a controlling shareholder borrows from a corporation. To avoid constructive dividend treatment, the owners of a corporation should observe certain formalities when making withdrawals. Whenever practicable, a withdrawal that's intended to be a loan should be documented as such, with a legally enforceable promissory note that pays sufficient interest, and the transaction should be reflected as a loan on the corporation's books and records. Further, repayments should be made in accordance with the terms of the note.
Background. A dividend is a distribution of property from a corporation to its shareholders out of the corporation's earnings and profits. (Code Sec. 316(a)) The amount of the distribution equals the fair market value of the distributed property on the distribution date. (Code Sec. 301(b)(1), Code Sec. 301(b)(3)) For the years at issue in the Rowells' case (2000-2002), dividend distributions were taxable as ordinary income.
RIA observation: For tax years beginning after Dec. 31, 2002 and before Jan. 1, 2011, §301 of the 2003 Jobs and Growth Act (JGTRRA, P.L. 108-27, 5/28/2003), as amended by §102 of the 2005 Tax Increase Prevention Act (TIPRA, P.L. 109-222, 5/17/2006), provided that qualified dividend income was taxed at the same rates that apply to net capital gain. The recently enacted Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312, 12/17/2010) has extended for two years the taxing of qualified dividend income at capital gain rates—0% and 15%—to tax years beginning before Jan. 1, 2013.
The amount of a distribution that exceeds earnings and profits, and is therefore not a dividend, is taxable capital gain to the recipient. (Code Sec. 301(c)(3)) Under long-established case law, dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation confers a benefit on a shareholder by distributing available earnings and profits without expectation of repayment.
In seeking to determine if a corporate distribution to its shareholders is a non-taxable loan, as is sometimes claimed, courts have analyzed the following objective factors:
(1) Whether the promise to repay was evidenced by a note or other instrument;
(2) Whether interest was charged;
(3) Whether a fixed schedule for repayment was established;
(4) Whether collateral was given to secure payment;
(5) Whether repayments were made;
(6) Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and
(7) Whether the parties conducted themselves as if the transaction was a loan. (Welch v. Com., (CA 9 2000) 85 AFTR 2d 2000-1064, affg TC Memo 1998-121)
Facts. John Rowell was a trial attorney who practices law through his wholly owned corporation, Professional Law Corp (PLC). His wife, Kathleen Rowell, was a television and screen writer as well as a buyer and seller of vintage dolls and similar collectible items, who worked through her wholly owned corporation, Knutsen-Rowell, Inc. (Knutsen).
During the years at issue, the Rowells took funds from PLC's and Knutsen's operating accounts for their personal use. They took those funds through checks, withdrawals, and transfers, and used the funds to pay their living expenses (including the expenses of their children) or otherwise spent them at their discretion. With one exception, none of the transactions underlying the taking or the use of those funds related to PLC's or Knutsen's business, and the Rowells didn't report any of those funds as a distribution (or other type of income).
On audit, IRS adjusted the Rowells' income to reflect its determination that they had received constructive distributions from their corporations. IRS also made various other adjustments to reflect other disputed matters. The Rowells sought relief in the Tax Court, and the separate cases dealing with the Rowells', PLC's, and Knutsen's tax liabilities were consolidated.
Court's decision. The Tax Court concluded that the Rowells were taxable on the constructive distributions from PLC and Knutsen. The Court rejected the Rowells' self-serving statements of intent that the distributions were repayments of shareholder loans and so were erroneously characterized as distributions. Instead, the Court scrutinized objective indicia of debt to determine whether the Rowells and their corporations intended at the time of the distributions to create a bona fide debtor/creditor relationship.
While recognizing that shareholders and their closely held corporations may sometimes be lax in formalizing their dealings with each other, the Tax Court nevertheless found that the Rowells and their corporations failed to establish that the requisite bona fide debtor/creditor relationship existed between them at the time of any of the distributions. Neither conducted themselves as if the distributed amounts were loans. The purported loans weren't evidenced by notes or other writings. They weren't secured by collateral. They didn't require the payment of interest. They weren't subject to repayment schedules or to any specific terms of repayment. Neither the Rowells nor the corporations recorded the amount of any loan between them or otherwise kept track of them accurately. The distributed amounts weren't contemporaneously designated as the proceeds or the repayment of a loan.
The Court also wasn't persuaded that either the Rowells or their corporations had sufficient funds either to make loans of the magnitude made or to repay loans of the magnitude claimed.

Knutsen-Rowell, Inc., et al., TC Memo 2011-65