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The Online Advisor - September 1998
Shareholder loans carry tax risks
As a shareholder in a closely-held corporation, you may occasionally look to your company for needed cash. One commonly used method to extract money from small companies is the shareholder loan, but it’s a method fraught with risk. Unless carefully structured and documented, the IRS could treat such a loan as a dividend.
Is it a loan or a dividend?
The distinction between "loan" and "dividend" has important tax consequences. For example, dividends paid by a regular (or "C") corporation are generally treated as taxable income to the shareholder. Even if your corporation can’t declare a dividend because it doesn’t have sufficient "earnings and profits," you may incur a tax liability if you withdraw cash.
For a C corporation, withdrawals that exceed earnings and profits are tax-free until they equal the shareholder’s stock basis. Beyond that point, withdrawals are treated as capital gains.
If you’re doing business as an S corporation, withdrawals are tax-free to the extent of your "accumulated earnings account." Beyond that point, the tax consequences of withdrawals are generally the same as for a C corporation.
Is it an "arm’s length" transaction?
How does the IRS decide whether a withdrawal is actually a loan or a dividend? As a rule, the IRS tries to determine whether the transaction was conducted at "arm’s length" – in other words, did the corporation treat the shareholder who received the withdrawal as it would an outside party who tried to borrow money?
What can you do to assure loan status?
Here are some tips to help ensure that your shareholder loan doesn’t turn into a dividend:
- Execute a formal promissory note that provides for a regular repayment schedule.
- Specify an interest rate that’s at least as high as the prime rate at the time the loan is made.
- Carry the loan as a receivable on the books of the corporation.
- Furnish collateral to secure the loan.
- Make the loan for a fixed term, rather than an indefinite period.
- Don’t take withdrawals so large that they call into question your ability to repay them.
- Repay the loan according to the repayment schedule and the terms of the promissory note.
Because shareholder loans can trigger significant tax consequences, careful planning is especially important. Be sure to contact us prior to any transaction so that it can be properly structured to avoid running afoul of IRS rules.