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Understanding the tax ramifications of shareholder loans

Nov 21, 2017

By Charles R. Kennedy, CPA, MBA
Director of Tax Services

Owners occasionally borrow funds from their businesses. You may, for example, need an advance to cover your child’s college costs or a down payment on a vacation home. If your company has extra cash on hand, a shareholder loan can be a convenient and low-cost option — but it’s important to treat the transaction as a bona fide loan. If you don’t, the IRS may claim the shareholder received a taxable dividend or compensation payment rather than a loan.   

But there are ways to protect shareholder advances from IRS scrutiny.

A closer look at AFRs

You can make de minimis loans of $10,000 or less to shareholders without the payment of interest. But, if all of the loans from the business to a shareholder add up to more than $10,000, the advances may be subject to a complicated set of below-market interest rules unless you charge what the IRS considers an “adequate” rate of interest. Each month the IRS publishes its applicable federal rates (AFRs), which vary depending on the term of the loan.

As long as a company charges interest at the AFR (or higher), a shareholder loan would be exempt from the below-market interest rules the IRS imposes.

The interest rate for a demand loan — which is payable whenever the company wants to collect it — isn’t fixed when the loan is set up. Instead it varies depending on market conditions. So, calculating the correct AFR for a demand loan is more complicated than it is for a term loan. In general, it’s easier to administer a shareholder loan with a prescribed term than a demand note.

Below-market loans

If your company lends money to an owner at an interest rate that’s below the AFR, the IRS requires it to impute interest under the below-market interest rules. These calculations can be complicated. The amount of incremental imputed interest (beyond what the company already charges the shareholder) depends on when the loan was set up and whether it’s a demand or term loan.

Additionally, the IRS may argue that the loan should be reclassified as either a dividend or additional compensation. The company may deduct the latter, but it will also be subject to payroll taxes. Both dividends and additional compensation would be taxable income to the shareholder personally, however.

Bona fide loans

When deciding whether payments made to shareholders qualify as bona fide loans, the IRS considers:

  • The size of the loan
  • The company’s earnings and dividend-paying history
  • Provisions in the shareholders’ agreement about limits on amounts that can be advanced to owners
  • Loan repayment history
  • The shareholder’s ability to repay the loan based on his or her annual compensation
  • The shareholder’s level of control over the company’s decision making

The IRS also will factor in whether you’ve executed a formal, written note that specifies all of the repayment terms. The loan contract should spell out such details as the interest rate, a maturity date, any collateral pledged to secure the loan and a repayment schedule.

S-Corporation loans

Special care should be taken for loans to S-Corporation shareholders. Without evidence of it being a loan there is risk that the IRS could recharacterize the loan as a shareholder distribution. For S-corps with more than one shareholder, this could be deemed a distribution that is not following ownership percentages, which is an S-corp requirement. This could result in the S election being blown, causing the S-corp to be reclassified as a C-Corporation, which could have serious tax consequences.

Getting started

Under the right circumstances, a shareholder loan could be a smart tax planning move. Contact us for more information. We can help set up and monitor your shareholder loans to ensure compliance with the IRS rules.

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