ASK THE EDD ATTORNEY – WHEN IS A LOAN ONE THAT THE EDD WILL RECOGNIZE?
By Robert S. Schriebman
January 14, 2015
An EDD audit can have several objectives. One objective is to determine proper worker classification – is a worker an employee or independent contractor? Another EDD objective is to determine the amount of taxable compensation. The EDD makes money on taxing the proper amount of compensation. Wages are wages, but wages may not include funds received as a loan from one’s employer. In small corporations we see attempts by corporate officers to reduce the amount of taxable compensation by treating the receipt partially as compensation and partially as a loan. S Corporations try to treat part of corporate distributions as a non taxable return of capital, but this is a subject of another article.
Internal Revenue Code Section 61 defines income by fifteen categories of receipts. One category is “compensation for services, including fees, commissions, fringe benefits, and similar items.” It goes on to state that gross income means income derived from business. This statute governs how both the IRS and the EDD determine taxable wages.
Internal Revenue Code Section 61 does not state that loan proceeds are considered income. Because of this distinction shareholders of small corporations will try to reduce the amount of taxable income i.e. wages by taking out proceeds as loans.
THE EDD’S APPROACH TO SMALL BUSINESS LOANS
When an EDD auditor conducts an examination he or she will request the usual documentation such as the business general ledgers and bank statements. Savvy auditors also ask for bank statements of corporate shareholders and officers. When the auditor starts to see documentation and information concerning loans the auditor becomes very suspicious. Almost automatically the auditor takes the world view that the owners of the company are attempting to take money out of the business without paying California taxes such as unemployment insurance (UI), disability insurance (DI), and personal income taxes (PIT). The auditor looks for a way to disregard the loan and treat the loan proceeds as taxable wages. It is an uphill battle to attempt to convince the auditor that any loan from a closely held business is truly a bonafide loan.
WHEN IS A LOAN A REAL BONAFIDE LOAN?
We all live in a modern electronic era where the computer has become central to both or personal and business lives. We keep our business information on computers. When we are audited by the IRS or EDD we tend to prove our income and deductions by computer documentation. Before we had computers we took written minutes of corporate transactions. We created memos and killed a lot of trees to get paper. Now we live in a world where the goal is paperless transactions. This does not work well when it comes to loans.
Over the years I have handled many audits and many transactions involving loans. I have found that it is still essential to convince any tax auditor that a bonafide loan for a small corporation must have as its foundation proper corporate minutes reflecting the granting of a loan to a shareholder from the corporation. These minutes are known as Special Minutes. They are distinguished from Annual Corporate Minutes where the Board of Directors is elected by the shareholders, and the Board in turn hires corporate officers. In addition to the Special Minutes reflecting the terms of the loan, a valid loan must also have a proper Promissory Note. Forms for these notes can be obtained on the internet or can be purchased at office supply stores such as Staple, Office Depot, etc. Stationary stores also sell them.
BOTTOM LINE TO SUCCESS
If you want to survive an IRS or EDD audit and prove that a loan is truly a loan you must have appropriate Corporate Special Minutes and a well drawn Promissory Note. However, that is not enough. There must also be evidence that the note is being paid back to the corporation with interest.
If the corporation cancels the note and forgives the indebtedness the corporation must file Form 1099-C, Cancellation of Debt, if the cancelled debt is at least $600.
An EDD attorney, Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States.
As a trusted EDD lawyer, Robert S. Schriebman 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.
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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