WorldWide Drilling Resource

81 WorldWide Drilling Resource ® DECEMBER 2014 Drilling Into Money Not Boring by Mark E. Battersby Money-In, Money-Out For many drilling businesses, bor- rowing means a loan from the owner or shareholder or, in some cases it is the owner or shareholder who borrows funds from the drilling operation. Loans and ad- vances between these so-called "related parties" are quite common in closely-held businesses. Corporate loans to shareholders are probably the most commonly seen by Internal Revenue Service (IRS) auditors, with advances from shareholders to the incorporated drilling operation running a close second. Generally, money invested in the business can be withdrawn - with a tax bill on profits from the sale of that capital investment. A loan made by a profession- al drilling contractor to his or her business can, on the other hand, be repaid tax- free - if it is a bona fide, arm’s-length transaction. The tax rules are quite clear - only bona fide loans and contributed/invested funds qualify for any sort of tax break. When either lending to or borrowing from the drilling business, every owner, part- ner, and shareholder should keep in mind: to count in the eyes of the IRS, a transaction must be a legitimate, inter- est-bearing loan. Should the IRS recharacterize or relabel a transaction, the result is an interest expense deduction when none was previously claimed by the borrower and unexpected taxable interest income on the lender ’s tax bill. The lender ’s higher tax bills, tax bills that can date back several years, are usually accom- panied by penalties and interest on the underpaid amounts. The IRS's interest in these trans- actions stems from the tremendous po- tential for tax avoidance - inadvertent or intentional. Although there is a $10,000 de minimis exception for compensation- related and corporate/shareholder loans, at least those who do not have tax avoid- ance as their purpose, whenever an in- corporated drilling business makes an interest-free (or low-interest) loan to a shareholder, the shareholder is consid- ered as having received a nondeductible dividend equal to the foregone interest. The incorporated business, at the same time, has received a like amount of in- terest income. Today, doing it yourself or keeping financing in the family will often produce the fastest and best results. Obviously, while this transfer of taxable income between entities may appear to be off- setting, there may be a significant tax impact. The complexity of the tax rules, the requirement for all transactions to be conducted at "arm's length", have a bona fide economic purpose rather than mere tax avoidance, and be properly structured, obviously requires profes- sional guidance for every professional drilling contractor wishing to avoid pay- backs and penalties. Mark michele@ worldwidedrillingresource.com