Money In, Money Out (Part 1)

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Mark E. Battersby |

Understanding rules governing drycleaning business investments, withdrawals

ARDMORE, Pa. — Putting money into a drycleaning business, or taking money from the business, is not something to be tackled by amateurs. Admittedly, a surprising number of cleaners depend on themselves when it comes to financing their businesses. Thanks to our complex tax rules, however, getting money invested out of the business can be expensive.

Quite simply, money invested in the business can be withdrawn with a tax bill on any profits from the sale of that capital investment. A loan made by an operator to his or her business can, on the other hand, be repaid tax-free, but only if the ever-vigilant Internal Revenue Service accepts it as a bona fide arm’s length transaction.

On a similar note, it can also be expensive for any owner, partner or officer who attempts to take money from their drycleaning business. Once again, there is the risk the IRS might view the movement of funds from the business to the owner, partner, officer or shareholder as a taxable event.

IMPUTED INTEREST

It should be increasingly obvious that something as apparently simple as taking money from a business or even putting funds into the business can be painfully expensive under our tax rules. Those tax rules are quite clear: Only bona fide loans and contributed/invested funds qualify for any sort of tax break. When either lending to, or borrowing from, the business, every operator should keep in mind that in order to count in the eyes of the IRS, any transaction must be a legitimate, interest-bearing loan. Under our tax rules, an owner, partner or shareholder borrowing from his or her business can face a hefty tax bill should the IRS view the transaction as a dividend payout rather than a loan.

All too often, it is below-market interest rates or the lack of evidence of an arm’s length transaction that draws the attention of an IRS examiner. The IRS is particularly interested in gift loans; corporation-shareholder loans; compensation loans, between employer and employee or loans between independent contractor and client; and any below-market interest loan in which the interest arrangement has significant effect on either the lender’s or borrower’s tax liability.

Should the IRS re-characterize or re-label a transaction, the result is an interest expense deduction when none was previously claimed by the borrower and the addition of unexpected taxable interest income for the lender. The lender’s higher tax bills, which can date back several years, are usually accompanied by penalties and interest on the underpaid amounts.

ALWAYS A BORROWER BE

For many textile service businesses, borrowing means a loan from the owner or shareholder. In some cases, it is the owner or shareholder who borrows funds from the drycleaning operation. Loans and advances between these so-called “related parties” are quite common in closely held businesses. Corporate loans to shareholders are probably the most commonly seen by IRS auditors, with advances from shareholders to the incorporated business running a close second, particularly in the early years of closely held but thinly capitalized corporations.

The IRS’ interest in these transactions stems from the tremendous potential for tax avoidance, inadvertent or intentional. When an incorporated drycleaning business makes an interest-free (or low-interest) loan to its shareholder, in the eyes of the IRS, the shareholder is deemed to have received a non-deductible dividend equal to the amount of the foregone interest. The incorporated business is, at the same time, deemed to have received a like amount of interest income.

Fortunately, there is a $10,000 de minimis exception for compensation-related and corporate/shareholder loans, at least those transactions that do not have tax avoidance as one of the principal purposes.

Although this transfer of taxable income between entities may appear to be offsetting, there can be a significant tax impact on the reallocation, depending on the relative tax benefits to the borrower and to the lender and the deductibility of the expense deemed paid.

DOWNSIDE: STOCK OR LOAN

When IRS examiners review loans from shareholders and the common stock accounts of a drycleaning business, they often encounter what can only be called “thin capitalization.” Thin capitalization occurs when there is little or no common stock and there is a large loan from the shareholder. A special section of the tax law, Section 385, Treatment of certain interests in corporations as stock or indebtedness, governs whether a loan is one made to an incorporated business or treated as debt.

The IRS’ objective when it encounters thin capitalization is to convert a portion, if not all, of the loans made by the shareholders into capital stock in the business. Naturally, this conversion requires an adjustment to the interest expense account, because, at this point, the loans are considered nonexistent. The interest paid by the incorporated business on these disallowed loans becomes a dividend paid to the shareholder in an amount equal to the operation’s earnings and profits.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an attorney or tax adviser for advice regarding your particular situation.

Check back Thursday for the conclusion!

About the author

Mark E. Battersby

Freelance Writer

Mark E. Battersby is a freelance writer specializing in finance and tax topics. He is based in Ardmore, Pa.

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