A Tale as Old as Tax Evasion
If you’ve worked in the tax world for long, you may be familiar with this chain of events: a corporation has negative retained earnings, and their tax planner is hesitant to flag the problem. So instead, the tax planner opts to quietly reclassify that money as a shareholder loan.
The same thing comes up with taxable dividends. The C corporation wants to avoid paying that tax, so what if we just reclassify those dividends as a shareholder loan?
If you’re familiar with the rules around shareholder loans, a red flag should have gone up. A shareholder loan cannot be used as a workaround for owners to take money out of the business without getting taxed. Even if you have legitimate grounds for a shareholder loan, this may not even be the wisest tax savings strategy.
Taxable Dividends Are Not Always the Enemy
Tax planners sometimes get tunnel vision when it comes to taxable income. Without conducting a full assessment of the situation, they set their sights on just one goal: avoid recognizing the dividend at all costs. Is this always the best move for a client’s tax bill?
Surprisingly, the answer may be “no.” What if, for instance, we’re overlooking an opportunity for the taxpayer to enjoy a 0% or 15% tax rate on qualified dividends? If we are sitting on a favorable tax outcome and the shareholder needs that income, then why are we trying so hard not to recognize that dividend? Pause and consider whether there could be a benefit to recognizing that income now.
When a Loan is the Right Move
What if the problem is taxable dividends that would get hit with the maximum tax rate or negative retained earnings in a year when the owners were banking on those dividends? Now we return to the question, “Is a shareholder loan a possibility?” To keep everything above board, we need to be familiar with the qualifications for a legitimate shareholder loan:
- An arm’s-length treatment of the transaction: This is the key to all of the shareholder loan requirements. To put it simply, “Would we use the same terms and requirements if we were giving this loan to someone we didn’t know?” If the corporation is providing an unreasonably favorable setup to a shareholder because they’re a shareholder, then we are setting ourselves up for an IRS audit.
- A debt instrument: If we are treating this loan like an arm’s-length transaction, then logically, we would have a binding contract. We would require the borrower to repay the loan within a set period of time. We would likely charge interest. All of these things also need to be in place with a shareholder loan.
- A stated interest rate: This is the base interest rate before adding in compounding or fees. To ensure that this is treated like a typical loan, the interest rate needs to be at least equal to the monthly IRS Applicable Federal Rate (AFR), which can be found on their official website. Without a standard interest rate in place, the IRS could impose penalties or imputed interest down the road.
If the shareholder is actually in need of a loan and these requirements can be met, this option can safely become part of your tax planning conversation.
No Secret Rescue Missions, Please
If you are going to do great tax planning work for your clients, don’t do it in secret. Well-meaning tax planners sometimes quietly fix problems on the tax return, thinking they are doing the client a favor by alleviating their stress. In reality, this can just set the client up to repeat the same financial mistakes and can set you up to constantly be doing unpaid work. No one really wins in the end.
To use shareholder loans as an example, if you quietly try to resolve negative retained earnings with a loan, you’re simply setting off a chain reaction of future problems. The client will not realize they should not be distributing dividends. Instead of resolving the financial issues that led to the negative retained earnings, the problem simply gets worse. Then you find yourself in the same position the next year—tempted to use a “solution” that isn’t a real solution and will eventually get flagged by the IRS.
Instead, see it as part of your job to say what needs to be said. The taxpayer is relying on you to notice tax planning mistakes they missed and help them identify a viable solution. Relaying hard truths and recommending solutions is the way to win the respect of the type of clients you want.
Put Your Value on Display
At the American Institute of Certified Tax Planners, we focus on how to provide immense value to our clients and how to communicate that value clearly. This can be the difference between building a thriving tax practice with clients who collaborate on their tax plans versus burning out chasing after clients who take your work for granted. Your tax strategy doesn’t stop at knowing all the right tips and tricks. Building trust with your clients and teaching them what they need to know to get on board with your tax plan can be more than half the battle.
Invest in both skill sets today by signing up to become a Certified Tax Planner today!
