Tax efficient setup for partnership

My friend has 50% share in 2 person New York s-corp. I want to lend money to my friend with following conditions using some legal vehicle (promissory note/contract etc):

1. Collateral: His interest in s-corp.

2. Entitle to 30% of his annual profit share.

3. Entitle to 30% of his share if the business is sold.

4. There should not be any taxes on initial investment.

5. Be as tax efficient as possible for both of us. There should be no double taxation, I will pay taxes on the profit I receive but my friend should be able to deduct whatever he pays me on his taxes.

I cannot become part of s-corp or directly lend money to s-corp as other 50% partner in s-corp does not want to deal with it.

Answer :

I guess m aking your loan to S corp shareholder can be good tax planning. Making a loan to S corp shareholder can also lead to disaster.If the loan is recharacterized as a distribution and the shareholder has insufficient tax basis in his stock, taxable gain results for him. Even worse, if there is more than one shareholder, a loan to one shareholder that is recharacterized into a distribution could result in termination of the S election. The IRS could determine that the disproportionate distributions indicate a second class of stock;to avoid disaster, proving that a disbursement to a shareholder was intended to be a loan is the key. Proving “intent” depends on all the facts and circumstances.There are the main factors that the courts have deemed indicative of a bona fide loan: Whether the shareholder repaid the loan; Whether the shareholder paid interest on the loan; How the disbursement to the shareholder was reflected in the books of the corporation;as you said, Whether there was a promissory note with stated interest, a repayment schedule, and a maturity date; Whether or not security was given for the payments; Whether the corporation tried to enforce repayment; Whether the shareholder was financially able to repay

According to the case law, by far the most important indicia of a bona fide loan between the lendse(or sh/owner of S corp) and corporation is repayment. Several times courts have ruled that a loan existed even if there was no written note and the bookkeeping was sloppy, but the disbursements were later repaid.What if the S corp client has had loans outstanding for years and the loans keep growing? In that instance, you need to do two things: have a conversation with the shareholder about the risk of recharacterization, and insure the documentation of the loan is proper. If the S corp is growing and profitable, strongly suggest to the debtor/shareholder that earnings be used to make distributions so that the shareholder can repay the loan. If there is more than one shareholder, remember that distributions must be proportionate to ownership. As the debtor/shareholder borrow from you, a third party, in order to repay the loans to the S corp. This suggestion likely won’t be greeted with enthusiasm either. But if the tax risk of recharacterization is significant and other opportunities for repayment are limited, then this may be the best option. if the S corp’s business has appreciated in value, but the...Read More...