Small Business Taxes & Management

Special Report

Advances to Supplier Were Equity Investments for Tax Purposes


Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.


It's not that unusual to be closely tied to one supplier or customer. In the case of a supplier, he may be the sole source (or the most convenient) for an important product. In one case a number of years ago, Madison was in the business of selling heating, ventilating, and air conditioning equipment. Madison bought most of its fans from Chatham Equipment, Inc. Chatham was in poor financial shape, but the company represented such an important portion of Madison's business that if Chatham should fail, Madison might be forced out of business.

Madison soon began making advances on job orders that Chatham could not fill because it had insufficient funds to manufacture the orders. Madison also made advances for Chatham's general operating expenses, such as rent, workers' compensation insurance, and taxes.

Less than six months later the sole shareholder of Madison agreed to become a 50% owner of Chatham by contributing $10,000 of equity capital and a loan of up to $350,000 to Chatham. Within the month, Madison advanced Chatham $275,000. Madison made additional advances to Chatham and even started providing it with office supplies, etc. These transfers were recorded on Madison's books as accounts receivable/loans. Madison's owner did not increase his equity position in Chatham and Chatham did make some repayments on the advances.

About a year later, Chatham applied for a line of credit. On the balance sheet accompanying the application, the advances were presented as capital investments (i.e., equity). The following month, however, they were reclassified as short and long-term loans. The tax returns for two years showed the advances as equity. Madison's owner convinced a friend to loan Chatham $250,000 which he guaranteed. Madison advanced additional money. Madison and Madison's owner filed for bankruptcy not long thereafter. At that time Chatham owed them approximately $1.4 million.

The taxpayers claimed a business bad debt loss. The IRS held that the advances were equity capital, and that the taxpayers could only claim a capital loss (which can't be used to offset ordinary income; there's a $3,000 exception for individuals). The court examined the facts and concluded that the advances were equity capital. Among the factors that influence the court was the lack of formal debt instruments issued along with each advance; the lack of a specific maturity date, the fact that the taxpayer participated in the management of the company (owners have a say in management; creditors don't); the parties represented the advances as equity capital; the business was thinly capitalized (i.e., very little equity capital); and Chatham could not obtain loans from regular lenders. The most damaging evidence may have been that the taxpayer represented the advances as equity capital when applying for a line of credit and that the advances were listed as equity on the tax returns.

There are a number of lessons here--both business and tax. First, it was a mistake for Madison's owner to loan money to Chatham in the first place. It seems clear the business was doomed from the start.

Second, Madison's owner could soon see the business was a sinkhole, yet continued to advance funds. The business was hemorrhaging cash as quickly as it was put in. There comes a time to cut your losses.

Third, there's a time to call in professional help. Even based on the limited information in the case and the magnitude of the losses, it appears there were other factors here. An analysis of Chatham's expenses should have revealed some other reason for the losses. During the dotcom era businesses went under because of start-up expenses, high advertising costs and minimal revenue. None of those seem to have been present here. Embezzlement is often an issue. Some money spent on a CPA might have provided an answer.

The fourth lesson was letting a bad debt deduction slip away. Formalizing the advances, setting a maturity date, and consistently representing the advances as loans on the books sill may not have convinced the court, but at least the taxpayer would have stood a chance. That's especially true in this case. It's tough to secure a business bad debt deduction (which isn't treated as a capital loss). But advances to suppliers are one of those reasons that qualify. Again, some good advice may have saved the day.

Finally, while it didn't happen here, taking too much control of a debtor can result in the lender becoming liable for unpaid payroll taxes and similar obligations.

Business decisions, particularly for small businesses can become involved. You may be dealing with a long-term supplier or customer, or one who's in the same small town. In some cases you may even be related. That makes decisions much more complicated. When a big company makes a decision they almost always look at just the numbers. Close a plant in a small town and create a 25% unemployment rate? That's not a consideration. You may have a good nonbusiness reason to try and bail out a business, but make sure you do it the right way and that it doesn't drag you under. And get good advice.  

Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 08/21/14