If you are the owner of a sole proprietorship, single-member LLC, or other individual business venture, it is important to document your transactions, even if they only involve you (the business owner) or other related parties. Let’s say, for example, there is corporation with two shareholders that needs more equity to grow the business.Both shareholders agree to extend a loan to the company and with the expectation of getting reimbursed within five years. Even though this may seem like a fairly banal financial transaction involving owner-money in a business, it still needs to be properly documented to protect the business owners from potential adverse legal and tax ramifications.
If the two shareholders extend a loan to the corporate entity, the corporate entity is required to make payments back to the shareholders with interest.This would enable the corporate entity to deduct the interest payments as an expense. As a result, the two shareholders would not need to pay taxes on the principal of the loan, but they would be subject to taxes on the interest payments received.
Unfortunately, many small business owners in Los Angeles and elsewhere fail to take the time to properly document this type of financial transaction.Some business owners may take the time to enter it into their accounting books, but they neglect preparing any type of formal loan document, nor do they prepare any board resolution authorizing the corporate entity to take on the loan. Many business owners simply view the loan as something between themselves. The notion of creating a formal loan document seems like an inefficient allocation of time and funds. However, the lack of formal documentation exposes the business owners to potential legal issues down the road.
Failing to have proper legal documentation could expose the business owners to a stressful and invasive audit by the Internal Revenue Service. If your business is the subject of an IRS audit, they will likely request a copy of any loan documents and resolutions authorizing the transaction. If the business owners cannot produce such documentation, the IRS could potentially recharacterize the transaction as a dividend. If that occurs, the loan interest is no longer tax deductible. This means the business owners would then be required to pay double taxation on the interest.Furthermore, depending on the capital structure, the principal payments could be considered a taxable distribution, thereby causing the business owners to have to pay income taxes on the return of principal from their corporation.
Selling the Business
Another potential legal issue could arise if the business owners opt to sell an interest in the business or sell the business in its entirety.If there is no documentation detailing the loan transaction, it could cause issues with due diligence, which will likely be done by any legitimate business investor or purchaser.
Have Questions Related to Business Agreements or Financial Transactions? Speak to an Experienced Contract Attorney in Los Angeles Today
If you have questions about the steps necessary to create a formal loan document, lease, or other type of legal agreement, now is the time to contact the Hakim Law Group. The level of diverse legal and business expertise that the highly reputable professionals at Hakim Law Group attain is what sets HLG apart from the competition. For further information or to schedule a consultation please contact Hakim Law Group at (310) 993.2203 or visit www.HakimLawGroup.com to learn more.