It’s Not a Loan Just Because You Said So

A transaction may appear to be a loan on paper, but that alone does not guarantee it will be treated as a loan by the IRS. Increasingly, the IRS is scrutinizing the economic substance of loan arrangements to determine whether they reflect genuine indebtedness or are merely formalities designed to achieve tax benefits. 

If a loan lacks economic substance, meaning there is no real expectation of repayment, no consistent payment history, or terms that wouldn’t exist in an arm’s-length transaction, then the IRS may recharacterize it as taxable income or gifts. A promissory note, by itself, is not enough to withstand audit scrutiny. In order to pass muster with the IRS, the loan must have economic substance behind it to prove that it is a real debt owed by the borrower. 

Economic Substance

For a loan transaction to have economic substance, it must have a business purpose that changes a taxpayer’s economic position in a meaningful way. This means that the transaction must have a potential economic upside or downside. The taxpayer must also have a substantial purpose for entering into the transaction, separate from any federal income tax consideration. If the taxpayer’s sole reason for entering into a transaction is to take a tax deduction, the IRS is likely to find that the loan lacks economic substance. 

Stevens v. Commissioner 

In a recent case, Stevens v. Commissioner, the Tax Court examined a loan transaction involving a California couple who claimed over $34 million in interest deductions between 2014 and 2016. The Court found that the transaction lacked economic substance because the promissory note included a self-canceling clause, which effectively relieved the borrowers of any obligation to repay the debt. As a result, the Court concluded that no true debt existed. 

How to Make Your Loan Hold Up 

To avoid reclassification and have your loan respected for tax purposes, it should meet the following criteria: 

1. Written Loan Agreement – You should have a formal, signed document outlining the terms of the loan. 
2. Reasonable Market Interest Rate – The interest rate should reflect what an unrelated third party would charge. 
3. Fixed Repayment Schedule – The loan agreement should contain clear terms for repayment, including due dates and amounts of monthly payments. 
4. Enforcement Provisions – The agreement should outline the legal recourse available to the lender if the borrower fails to make payments. 
5. Evidence of Actual Payments – The borrower should be able to demonstrate that consistent payments have been made according to the schedule set out in the agreement. 
6. Intent and Ability to Repay – This would be demonstrated through financial records and borrower conduct. 

If the loan transaction does not reflect a real-world lending relationship, it may not survive IRS scrutiny, which could potentially lead to penalties and interest. Establishing economic substance when entering into a loan is not just good practice; it’s essential for protecting your tax position. Our controversy team has decades of experience representing clients before the IRS. Contact us below if you have questions.