Shared pockets spell tax trouble for ‘related’ parties

October 1, 2004

Excessive compensation, in the IRS's eyes at least, indicates that the principal/shareholder was attempting to avoid the double-tax due on dividend income-once at the corporate level and again as the personal income of the recipient.

All too often, the practice, the shareholder, and their tax advisers ignore not only these same-time transactions or cross-loans, but also the more routine shuffling of cash between the urology practice and its shareholder/principals. Unfortunately, the ever-vigilant Internal Revenue Service rarely ignores such transactions.

Prior to enactment of the lower (and temporary) tax rates for dividends, the IRS often cracked down on incorporated businesses, demanding that a portion of the operation's profits be distributed as dividends rather than as compensation. Excessive compensation, in the IRS's eyes at least, indicates that the principal/shareholder was attempting to avoid the double-tax due on dividend income-once at the corporate level and again as the personal income of the recipient.

An advance or a contribution? Generally, when a shareholder advances money to the corporation he or she controls, it is considered to be a contribution to capital with no tax consequences. Many other transfers, as well as loans between a shareholder and his or her incorporated medical practice, should call for interest payments.

Interest payments that are deductible by the borrower must be reported as income by the lender. A low or non-existent rate of interest on the transaction means, of course, that one party has a smaller tax bill. Since a business troubled enough to require an infusion of cash from its shareholders is unlikely to need another tax deduction, interest payments are often ignored or stated at a very low rate.

Any transaction between "related" parties-family members, a partner and his or her partnership, and a physician and his or her incorporated practice-is considered a related-party transaction unless it qualifies as "arm's length." With any transaction that is not at arm's length, the IRS has the power to re-characterize it. That means interest income, at a rate that the IRS deems fair, is paid retroactively to the lender and credited to the borrower. These retroactive hits on the lender can result in a substantial tax bill.

'Below-market' loans There are tax consequences for all so-called "below-market" loans between a corporation and any of its shareholders-even in those situations where both advances and repayments occur at the same time. Consider this example based on a situation revealed in a recent, non-binding decision by the U.S. Tax Court:

The case involved the cross-loans between ATV-an incorporated business with substantial gross sales-and its owner/shareholder, Paul Revere, who owned 45% of the shares. During 1997, ATV and Revere had open account indebtedness running between them, with no provisions for interest. At all times during 1997, Revere's debt to ATV exceeded its debt to him.

"Advances" to him were the result of personal items he purchased with his corporate credit card and child support payments made on his behalf by the corporation. Revere owned the ATV headquarters building, and the main "advance" from him to the corporation consisted of the monthly rent on that space, net of mortgage payments made by ATV on his behalf.