Tax Court denies corporate interest deduction

The Tax Court has held in Short Stop Electric, Inc. v. Commissioner (T.C. Memo 2023-114) that loans made by a corporation’s majority shareholder were capital contributions to the corporation rather than debt.

The case addressed a C corporation (Short Stop) owned by a husband (96% ownership) and wife (4%) (Mr. and Mrs. Boyum). Mr. Boyum owned 96% of Short Stop and Mrs. Boyum owned the remaining 4%. Short Stop had adopted the cash method of accounting.

Since 2009, Mr. Boyum extended a revolving line of credit to Short Stop, granting it the right to borrow up to $1 million with a maturity date of December 2019. The agreement had no stated interest, but Mr. Boyum would determine the interest rate of the loan each year retroactively. 

The agreement required monthly payments of interest, but allowed the corporation to add any unpaid interest to the principal of the loan. If the interest payments were not paid within 10 days of its due date, the loan would be in default and Mr. Boyum could demand payment and interest immediately. 

The interest payments were generally all treated as additions to the principal of the loan rather than paid in cash. As a result, Short Stop deducted the interest expense on its return and the Boyums included the interest in gross income on their joint return.

The Court agreed with the IRS that the interest deductions of Short Stop should be disallowed because the purported loans under the line of credit had more characteristics of equity than debt. Specifically, the court’s decision was based on the following:

• The interest rate for the loan was based on the corporation’s ability to pay and was determined by reviewing the general market and the corporation’s well-being.
• The reason for the debt arrangement was that, upon retirement or eventual sale of the corporation, he would be entitled to a repayment of the loan instead of paying capital gain.
• Another reason for the line of credit was the fact that the corporation was unable to secure other financing from outside banks without him personally securing the loans with his personal assets. 
• Short Stop’s non-payment triggered a default that gave Mr. Boyum the right to demand payment but he never did.

Without interest deductions, the corporation largely had no net operating losses to carry forward to the relevant tax years. In addition, the corporation had deducted various personal expenses of Mr. Boyum that were also at issue.