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Question: David Diehl is a 90% shareholder in GDS, Inc., a closely held C corporation. The corporation received a bona fide shareholder loan from David and is repaying him with interest. In a difficult economic time, the C-corp became unable to pay David the interest. It plans to start paying interest in two years. Can GDS accrue the interest for the two-year period and deduct it as an expense before actually paying David?

Answer: No. Under the general rule of §267(a)(2), a shareholder and a corporation are considered related parties when the shareholder owns more than 50% in value of the corporation’s stock.

Thus, it appears that David and the corporation are related.

Generally, in related party situations, an accrual-basis taxpayer is placed on the cash basis regarding the deductibility of items accrued, but not yet paid, to related cash-basis taxpayers. §267(a)(2) provides that the deduction is allowed on the day the amount is included in the recipient’s income.

Therefore, GDS, Inc. may only recognize the expense at the time the interest is actually paid.