During an IRS audit of a taxpayer that runs a business, it is not uncommon for the IRS to perform an analysis of a business’s bank deposits. If the taxpayer is not able to establish the source of the deposits, the IRS may consider the deposits to be taxable income. The taxpayer often instead considers the deposits to be nontaxable income such as proceeds of loans, capital contributions from the taxpayer, gifts, or even the business’s holding of the funds of others.
Courts often hold that “[d]eposits in a taxpayer’s bank account are prima facie evidence of income, and the taxpayer bears the burden of showing that the deposits were not taxable income but were derived from a nontaxable source.”[1] In Berry v. Commissioner of Internal Revenue[2], the taxpayers failed to establish that a $60,000.00 cash deposit from the taxpayers’ father to taxpayer’s business was a loan. The Ninth Circuit Court of Appeals referred to Welch v. Comm’r, 204 F.3d 1228, 1230 (9th Cir. 2000) for the factors to determine whether a deposit is considered to be a nontaxable loan:
- A loan is defined as “an agreement, either express or implied, whereby one person advances money to the other and the other agrees to repay it upon such terms as to time and rate of interest, or without interest, as the parties may agree.”[3]
- In classifying a loan, the court examines the transaction as a whole.[4]
- The conventional test is to ask whether, when the funds were advanced, the parties actually intended repayment.[5]
- Courts also look at other factors such as: 1) whether the promise to repay is evidenced by a note or other instrument; (2) whether interest was charged; (3) whether a fixed schedule for repayments was established; (4) whether collateral was given to secure payment; (5) whether repayments were made; (6) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and (7) whether the parties conducted themselves as if the transaction were a loan.[6]
Practice Point: Taxpayers should follow formalities of a bona fide loan if a business borrows money from its owners, family members or friends. The business should document the source of fund in bank accounts. If it does not, the business risks on audit the IRS determining that funds are taxable income rather than nontaxable loan process.
About the Author. Jared M. Le Fevre is a tax attorney and received a Tax LLM degree from the University of Alabama College of Law and a Juris Doctorate from the University of Utah College of Law. Mr. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal, state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
Date of information: March 1, 2023.
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[1] Welch v. Comm’r, 204 F.3d 1228, 1230 (9th Cir. 2000).
[2] Berry v. Comm’r of Internal Revenue, No. 19-70684, 2020 WL 6391104, at *1 (9th Cir. Nov. 2, 2020)
[3] Welch, 204 F.3d at 1230.
[4] Id.
[5] Id.
[6] Id.