The five Basics of a Complicated Process
I really hate trying to figure out my taxes, like presumably all our readers. Trying to understand, even in a superficial way, the ins and outs of how the tax laws treat certain transactions can be absolutely mind-numbing. But I am going to give it a go in this article, because owners loaning money to their companies to shore up cash flow in a new, evolving enterprise is a common type of transaction that can create tax complications for the unwary.
Five Basics of a Complicated Process
Each type of entity—be it a standard C Corporation, S Corporation, Limited Liability Company (“LLC”), or Partnership—are treated a bit differently under the tax laws when it comes to owner-related loans. So, for the sake of this example, let us discuss the scenario where an owner makes a loan to her multimember limited liability company.
1. Loans Do Not Generally Impose Tax Obligations on Lenders Except for the Interest Earned on the Loan
Generally, extending a loan to an enterprise and being paid back does not constitute a taxable event, save whatever interest the owner-lender may earn on the loan, which would be taxable as earned income. Being considered a loan is different from being considered a capital contribution to the company, which is a different type of transaction implicating different tax considerations. A loan must be evidenced by a promissory note, which details payment terms including the specific date by which the loan would be paid off and the interest on the loan.
2. Be Wary of the Consequences of Not Charging Loan Interest
Many owners making loans to their enterprises may be tempted not to charge interest, fearing that interest payments might burden the business’s cash flow, but this is not actually a good idea. That’s because the failure to charge interest may cause the IRS, retroactively, to impute interest income, which could create unexpected tax obligations for the lender. The IRS could also consider the loan a capital contribution, which could deprive the owner, lender, and company of certain tax benefits and visit upon them tax liabilities that might result from the misclassification.
3. How Cancellation of Debt Income Can Create Tax Liabilities for LLC Owners
However, there is a situation where extending a loan to an enterprise can result in a taxable event, imposing unexpected tax obligations not only on the lending owner, but on all the members of the LLC. This is the situation where the loan, which is counted as a “debt” on the books of the enterprise, is forgiven in whole or in part. The reason forgiving debt is a taxable event is because it creates a financial benefit to the company that the IRS considers “income.” So, if a $300,000 owner-related loan is canceled, the company is considered to have earned Cancellation of Debt Income in the amount of $300,000.00.
Now, it is fine and well for the company to reduce its debt, but what happens to the owners in a situation where there is Cancellation of Debt Income? Here is the rub: Limited Liability Companies, unlike standard C Corporations, are pass-through entities. In other words, company income and debt are passed through to the members of the LLC. If an LLC is being treated as a partnership, and earns $100,000 in a fiscal year, it is the members of the LLC who pay taxes on this income. The income passes through to the owners, each of whom are allocated a percentage of income under the Operating Agreement of the LLC and pay taxes on that amount.
The same is also true for Cancellation of Debt Income. The $300,000.00 loan written off by the lender might benefit the company by reducing its debt, but that benefit to the company—Cancellation of Debt Income—is also passed through to the owners who now must pay taxes on it. It requires no imagination to see that such a scenario can end up becoming a financial disaster for members whose income from the enterprise may not be sufficient to cover tax liabilities.
4. Can a Lender, Who Forgives Her Loan, Escape Paying Taxes on the Company’s Cancellation of Debt Income?
While the cancellation of a debt may be a financial benefit to the company, from the standpoint of the lender it constitutes a loss. The IRS allows such losses to be set off against income so, in the perfect world, even if the lender must pay taxes on the company’s Cancellation of Debt Income, the lender’s losses could be applied against that income, eliminating or substantially offsetting the tax liability. As I said, this would be the case in the perfect word, but no chance in the world of the IRS. The problem is that the tax authorities do not consider all “bad” debt to be the same.
In the cancellation of debt world, there is “Business Bad Debt” and “Non-Business Bad Debt.” As one source explains, “Business Debt” relates to loans made in the “ordinary course of the taxpayer’s trade or business.” As such, if a debt is canceled in whole or in part by a lender in the business of lending money, like a bank, such debt would be considered “Business Bad Debt.”
If, on the other hand, a debt is canceled by a lender that is not in the business of lending to businesses, like most members of an LLC, then such debt would be considered “Non-Business Bad Debt.” From the standpoint of the lender, the significance is this: Whereas Business Bad Debt can be set off against “ordinary income” as an “ordinary deduction,” Non-Business Bad Debt is considered a short-term capital loss that can only be applied against capital gains.
What this means in practice is that, for most members of LLCs who lend funds to their enterprises, writing off loans may not generate losses that will offset Cancellation of Debt Income, giving lenders little tax relief and rubbing salt in their wounds. Not only have they lost money on their loans but must actually pay taxes on these losses.
5. A Word for the Wise
A final word for the wise: Even if debt is not formally canceled, significantly modifying a loan in a way that would materially benefit a company financially, i.e., by reducing the overall debt obligation, might result in Cancellation of Debt Income, which has tax consequences.
The upshot is that making loans to one’s company or even modifying loans to reduce debt burdens could have tax implications that should be fully vetted by tax professionals. Pass-through entities, like limited liability companies, can save owners a lot of taxes, but passing through Cancellation of Debt Income can pose equally significant tax burdens.