ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – LENDING MONEY, THE EDD, AND COVID-19 – TRAPS FOR THE UNWARY
By Robert S. Schriebman
We all know that these are not good economic times for many small and mid-size businesses. Most businesses have been closed and may continue to be closed indefinitely. But eventually things change, they always do. When businesses re-open they may need an economic transfusion to start all over again. This article will discuss the risks involved for business owners lending to individuals, corporations and LLCs. Some businesses may not be able to pay back these loans and the owners may want to offset taxable income with a business bad debt loss deduction. Non-business loans that become defaulted, made be deductible as non-business bad debts.
Business loans are of interest to the EDD, not just the IRS or FTB. Business owners who have made loans to their business want to be paid back. Loan repayments are not taxable income, nor are they wages. The EDD often takes a dim view of loan repayments and seeks to treat these repayments as taxable wage distributions. Many auditors look for mistakes made by lender-owners in an attempt to invalidate the loan repayment and reclassify those payments as wages.
In October 2019, the Office of Tax Appeals (OTA), decided the case of Brett and Tracy Helm (OTA Case No. 18010769). The case involved the validity of a personal loan and whether the Helms could deduct the defaulted loan as a capital loss. The case is instructive because the OTA set forth a blueprint on how to properly structure and identify a loan as a valid indebtedness as opposed to a gift. Let’s look at the Helm case and the guidance on how to properly loan money for tax purposes, and to avoid EDD reclassification as taxable wages.
The OTA Helm Decision
Unlike most OTA decisions, the Helm matter involved the Franchise Tax Board (FTB) and not sales or use taxes. The Helm case is also interesting because the OTA based its reasoning and decision after consulting and citing U.S. Tax Court cases and an occasional U.S. District Court case. In my experience of arguing cases before California taxing agencies, I have found that whenever I attempted to use a federal tax case or IRS ruling, I was often informed that what applies to the federal government does not apply to the EDD and my federal legal points are given little weight. It seems that when the shoe is on the other foot, California taxing agencies are allowed to cite federal authorities as the gospel. That is what happened in the Helm‘s case.
Brett Helm loaned his father close to $650,000 in 2004 to go into several speculated real estate ventures that all went belly-up. The loan could not be repaid, so Brett Helm attempted to write-off the loss on his tax return as a non-business bad debt. Before the money was lent, Brett hired an attorney to prepare a brief promissory note. The note was subject to interest but there was no schedule for loan repayments.
The OTA held that the loan was not bona fide. In reality the loan was a gift to Brett’s father.
Basic Rule for Non-business Bad Debt Losses
If a non-business bad debt becomes totally worthless during the tax year, it will generate a short-term capital loss regardless of how long the debt was in existence. However, no deduction is allowed until the debt becomes totally worthless (IRC Sec. 166). Sounds straight-forward, doesn’t it? It is not so simple.
When Is a Loan Legally Recognized?
A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.
Here is what the OTA outlined in order to establish a valid indebtedness. These guidelines are useful in an EDD audit to prove that the loan is valid and must be recognized by the EDD so the EDD cannot argue that the loan repayments are disguised taxable compensation.
The factors used to determine whether a bona fide debt existed are:
- The promise to repay was evidenced by a note or other instrument;
- Interest was charged;
- A fixed schedule for repayments was established;
- Collateral was given to secure payment;
- Repayments were made;
- The borrower had a reasonable prospect of repaying the loan, and the lender had sufficient funds to advance the loan; and
- The parties conducted themselves as if the transaction was a loan.
For further reference see Welch v. Commissioner (9th Cir.2000) 204 F.3d 1228
Additional Requirements for Business Loans
The above elements are valid for both personal and business loans. The EDD only looks at business loans and its audits demand that the business, especially corporations and LLCs, also have corporate minutes and written promissory notes. I have seen more loans disregarded by the EDD because there were no corporate minutes authorizing the company to borrow money from a shareholder or officer.
There will be an unusual high demand for capitol in order to reestablish and operate businesses closed due to COVID-19. In order for these loans to be recognized as valid and legal all of the above elements must be met. Don’t forget the corporate minutes. May all your loans be successful, may they be paid back timely, and may your business thrive in a new era of prosperity.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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