In a classic example of the failure to follow thru with proper documentation on corporate tax planning and otherwise wishful thinking on the part of the accountant, the Tax Court in Indmar Products, ruled that cash transfers made to the taxpayer by its majority shareholders were capital investments and not loans. Therefore, the taxpayer was not entitled to interest expense deductions relating to the transfers.
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The taxpayer, a family-owned corporation, grew significantly from 1986 to 2000. The majority shareholders began transferring cash to the Company with the intent to take the cash back with interest as needed. Further, the shareholders sought to characterize the transfers as loans to reduce their estate tax burden and reduce the property received by their heirs. The transfers were unsecured and undocumented, and the taxpayer agreed to pay a 10% return on all transfers from 1987 through 2000. During this period, the prime rate fluctuated between 6% and 9.5%.
The Company made sporadic payments to the shareholders, based on the shareholders' financial needs, and not subject to set or predetermined dates.
On its federal income tax returns, the taxpayer reported the monthly payments to stockholders as an interest expense deduction. Consistent with this, the shareholders reported the payments on their income tax returns as interest income.
The IRS disallowed the taxpayer's interest expense deductions relating to the payments to the shareholders and consequently assessed deficiencies and accuracy-related penalties related to the taxpayer's 1998-2000 federal income taxes.
The Tax Court stated that taxpayers are entitled to a deduction for payments made on bona fide debt that relates to an existing, unconditional, and legal obligation to repay. However, transfers between related parties are examined with special scrutiny when taxpayers contend that such transfers are loans. According to the court, "the more a transfer appears to be an arm's-length transaction, the more likely the transfer will be considered debt."
The court determined that the transfers between the taxpayer and the shareholders were not arm's-length transactions for the following reasons: (1) The interest rate paid by the taxpayer was above the market and prime rates for almost 12 years; (2) The transactions were not documented for 8 years; (3) The taxpayer and the shareholders executed waivers that were violated and, at their convenience, considered nonbinding; and the Court felt that the transactions between the taxpayer and the shareholders did not take the same form as transactions between unrelated parties. Word count 486