Q: Please see details for question
I have removed the S election from a Delaware corporation in 2023.
At the end of 2022, there is about $500,000 of retained earnings.
I would like to distribute those funds in two separate loans, done sequentially, of $250,000 each.
The transactions would be completed before the end of 2023.
I would provide notes for each loan, and they would be at a market interest rate, interest only loans with an extended loan term that would be payable at the corporation's discretion at any time prior to that date.
My questions:
Is this allowed by IRS?
Are there any pitfalls with the approach that could result in auditing or penalties?
A:
In considering distributing retained earnings as loans from your Delaware corporation, it's essential to be aware of the IRS rules and potential pitfalls. The IRS allows corporations to issue loans to shareholders, but these loans must be structured and documented properly to avoid being reclassified as dividends or compensation, which could lead to tax implications and penalties.
The key is to ensure that these loans are bona fide, meaning they should have a formal loan agreement, a reasonable interest rate (consistent with market rates), a fixed repayment schedule, and you should actually make the repayments according to the terms. The corporation must also have an intent to enforce the repayment, and the borrower must have an intention to repay.
If the IRS determines that these loans are not genuine, but rather a means to distribute earnings without paying the appropriate taxes, this could be seen as an attempt to evade tax. Such a situation could potentially trigger an audit, and the IRS might reclassify the loans as dividends or compensation, leading to additional taxes, interest, and penalties.
Given the complexity and potential risks involved, it would be wise to consult with a tax professional or a legal advisor who can review the specific details of your situation. They can help ensure that your actions comply with IRS regulations and advise on the best approach to minimize any risks of audits or penalties. Remember, careful planning and adherence to legal and tax regulations are crucial in these matters.
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