Welcome to Just Answers! Thank you for giving me the opportunity to assist you! I will do my best to help!
Two things here:
First, I was just talking today to a colleague about amending returns that were 3 to 7 years old. There is a provision in the Internal Revenue Code that prevents REFUNDS after 3 years, but there is nothing that says you cannot still amend the return to get the correct information on the returns. He was amending old returns to properly report a capital loss that was being carried forward that had been incorrectly calculated in 2005. I am now amending 2006 to present to report RMDs that were not taken, and will result in a small amount of tax each year, but less than the tax that would be assessed if it was all reported in the current year. So, in theory, you COULD amend the old return to correct your basis!
Second, I found this on Loans to Shareholders:
To avoid problems, adopt the "walk-like-a-duck, quack-like-a-duck" strategy: Even though the shareholder may have truly intended the checks to be loans, the best way to convince the IRS of that fact is to follow all of the formalities, just as if the corporation were loaning funds to a stranger. Things like promissory notes, repayment schedules, a reasonable interest rate charge, and a track record of repayments-even if not perfect-can go a long way toward persuading an IRS auditor that the parties intended the payments to be loans.
Also, the tax code provides that a distribution made by a corporation with respect to its stock is a taxable dividend to the extent of a corporation's earnings and profits [IRC Sec. 301, 316]. Whether a shareholder's withdrawals from a corporation are loans or dividend distributions depends on whether, at the time of the withdrawals, the shareholder intended to repay the amounts received and the corporation intended to require repayment [Miele, 56 T.C. 556 (1971)]. On that issue, a shareholder's statement that he or she intended to repay can be considered. But the shareholder's statement won't prove the withdrawals were loans, especially in the case of a closely held corporation, unless it is supported by other facts indicating an arms-length transaction.
The following factors have been used by courts to determine whether a corporate advance is a loan or a dividend:
1. The extent to which the shareholder controls the corporation.2. The earnings and dividend history of the corporation.
3. The size of the advances.
4. Whether a ceiling existed to limit the amounts advanced.
5. Whether or not security was given for the loan.
6. Whether there was a set maturity date and repayment schedule.
7. Written evidence of a loan, such as an interest-bearing note.
8. Whether the corporation ever took steps to enforce repayment.
9. Whether the shareholder was in a position to repay the loan.
10. Whether there was any indication of attempts to repay by the shareholder (e.g., Nahikian T.C.Memo. 1995-161).
The Epps case (T.C. Memo. 1995-297) is a good example of how these factors are weighed. John Epps and his wife were the sole shareholders of EMSC Inc. From the time of EMSC's incorporation, John routinely withdrew corporate funds from EMSC for his personal use. These withdrawals were recorded on EMSC's books as stockholder advances, and as "'Other Assets'" on the company's financial statements. Epps never executed any promissory notes in favor of EMSC or secured any of the withdrawals with collateral. No specific schedule for repayment was ever established. No interest was charged on the amounts Epps withdrew, and EMSC never placed a limit on the amounts available to him.
However, Epps did make repayments by crediting year-end bonuses awarded by EMSC against his outstanding stockholder advances account. And, after the IRS started an audit of EMSC, Epps transferred title to the condominium in which he lived to EMSC, in return for which $80,000 was credited to the stockholder advances account.
The Tax Court said that the "absence of the standard indicia of indebtedness weighs on the side of a constructive dividend determination." There were no written agreements or notes evidencing the loans. No interest was charged on the amounts withdrawn. There was no ceiling limiting the amount Epps could withdraw. There was no security for the loans, no set maturity date, and no efforts by the EMSC to enforce repayments.
EMSC did not pass a corporate resolution authorizing the advances, and there were no corporate minutes substantiating any formal action taken by the corporation's board of directors. Epps placed a great deal of emphasis upon EMSC's accounting for the withdrawals as loans on its books as evidence of intent to repay the advances. The court responded that while this factor did work in Epps' favor, by itself it was no enough to prove the existence of bona fide loans.
The Tax Court also did not give much weight to Epps' "repayments." The court determined that EMSC's declaration of year-end bonuses and Epps' use of those bonuses to credit his loan account were simply bookkeeping entries designed to give his withdrawals "the color of loans." The court was also dismissive of the condo transfer to EMSC. Since the transfer occurred after the IRS began its audit of MSC, the court did not find it to be "persuasive evidence of an intention to create a real debt."
If the loan is payable on demand, the deemed payment to the shareholder and the deemed repayment to the corporation are treated as if they occur annually [IRC Sec. 7872(a)(2)].
So, as long as you make sure all your "I's" are dotted and all your "t's" crossed, you should be fine with a loan to shareholder.
I hope this answers your questions! Let me know if you have any more.
Thanks for all that Incredible information…..If this is reclassified as a loan it will act like a loan. Before making that determination, I want to make sure the facts gives 100% substantiation, for this error being classified as a loan instead of a shareholder distribution.
What was the original entry that was made in error? Can you give me the journal entry? Also the size, and the total assets of the corp?
The Accounting System is QuickBooks
The error has to do with supplies purchased at Office Depot and Staples from the Corporation Account.
The Problem was some of the supplies were used for personal use (About 5% for personal use)
It is the Policy of the Corporation to make sure Corporate Expenses are 100 Corporate expenses; for many apparent reasons.
During the Rush Period of doing Corporate Taxes it was stated to the Accountant/Bookkeeper, we need to figure out what portion of the expense was for personal use.
The Accountant put the entire expense in an account called “Research” to be reconciled. Later the entire amount was classified to Shareholder Distributions.
Chronology of Journal Entries:
Corporate Office Depot Credit Card CR
Corporate Staples Credit Card CR
Shareholder Distribution DR
The Shareholders never took distributions historically; just paid taxes on the K-1 profits and left the cash in the Corporation. This built up the Equity of the Corporation and the Shareholders had a large Positive Shareholder Basis.
It was decided currently to do a Cash Distributions to Shareholders, this is when it was noticed that the supply expense had reduced the Shareholders basis and the effects of this entry; the Corporation did not take an ordinary and necessary expense, creating larger K-1 profits to the Shareholders, and, now the Shareholder were to pay a 2nd tax because of S-Corporation Distribution in Excess of Basis.
The Shareholders understands and accept the Corporation lost an ordinary and necessary expense forever, and paid hire personal taxes as a result. This can not be changed.
The Shareholders are questioning:
This brings me back to the Original Questions asked:
This is a very small Corporation. I was just using a large Corporation has an example stating the possibility of a large Corporation making errors and finding them at some point in time in the future.
It is concluded that Corporations who has accounting errors and do not take an ordinary and necessary expense, will lose the ordinary and necessary expense forever and the Shareholders will pay higher personal taxes.
If it is concluded that a Corporation who finds an accounting error creates a double tax; the Corporation needs to set up better controls to ensure all ordinary and necessary expenses are taken to prevent the double tax in the future.
I like what you would do. If you don’t mind I would like to continue this discussion with you and I will double your Fee.
QUESTIONS – The answers to each of these questions will help shareholders decide to either Reclassify the supply expense sitting in Shareholders Distributions to Accounts Receivable or just pay the Capital Gains Tax—(Double Tax) for making the error.
Thank You…Very Much Appreciate your Answers.
The Shareholders do have the same principles and values; we are grateful to live in the USA and we believe in paying our share of taxes to protect the Country etc. Finding Shareholders with these qualities has built an incredible business relationship.
Note: The Shareholders electing to lose the Corporate expense for not taking them is the right decision, because it is the law. The Shareholders only want to pay their fair share and we feel there is something incorrect with declaring supplies, the company used as a Shareholder Distribution and paying another tax….Unless this is also the law, and then the shareholders will pay the 2nd tax.
YOU ANSWERED: When you state the shareholders will have to argue that the Corporation paid for supplies that the shareholders used.
No, I am not aware of any corporations that would take eliminated expenses as shareholder distributions. The only way I have seen them treated is as non-deductible expenses on the Schedule K-1. This would reduce the shareholder's basis in the corporation.
As far as the shareholders paying the first tax, this is an unusual way of looking at it. The fact that they gave up the full deduction that was allowed is beyond conservative. The tax code states in more than one place that the failure for a taxpayer to properly take a deduction or seek a reimbursement is not the IRS' fault, and that the Taxpayer is responsible for any tax on this failure. In your situation the IRS would see the failure of your accountant to properly amend the return during the three year period allowed as a problem for the Taxpayers to address, not the IRS.
After reading the facts as you stated them two posts above, I believe that the proper method would be go back and amend the return, which would not result in any refund due to the statute of limitations, but would correct the basis issues, or you could handle the expenses as a Schedule M-1 nondeductible item, which would also reduce the basis. In either case, the basis in the corporation would be reduced. The shareholders have paid an increased income tax four years ago, They now may face paying tax again if they do not have any basis restored and receive any distributions.
It is refreshing to see taxpayers who actually have ethics! I just discussed the importance of ethics in financial reporting in the class I taught tonight. It is one of those concepts that is so important to accurate financial and tax reporting.
One other thing to remember though. A famous Federal District Court judge, by the name of Judge Learned Hand, said that it was every taxpayer's duty to arrange their affairs so as to minimize the amount of tax that was paid, that there was nothing patriotic about overpaying tax! Google him sometime. He was a well-respected judge, and has many great quotes.
Thanks again for this great question! As I said, I have not seen anything similar to this in 28 years of practice!
So when the Schedule M-1 reduction, as I stated in an earlier response, is used as the proper treatment, the basis in the corporation would be reduced. Is this reduction the source of the distribution in excess of basis? Or is this reduction in basis causing a later distribution to be a distribution in excess of basis?
Any distribution that you classify as a loan would have to be documented as a receivable. However, this is only postponing the inevitable. There will be a time when the Shareholder will either have to pay the receivable (an actual cash cost to the shareholder) or take the receivable as a distribution (which would cause a distribution in excess of basis unless the basis has been restored through profits).