Avoiding Tax Problems with Shareholder—Corporation Loans

Owners of closely-held corporations will often either borrow money from the corporation or lend money to it.  Many times these arrangements are informal and not carefully documented.  In such cases it can appear as though the corporation’s bank account is functioning as if it were another personal account of the shareholder or vice versa.  These loose arrangements are problematic from an income tax point of view because the corporation and the shareholder are treated as distinct persons for tax purposes.

Poorly documented amounts borrowed from a corporation may be deemed instead by the IRS as a distribution.  For a C corporation, a deemed distribution is a dividend taxable to the shareholder and not deductible to the corporation.  For an S corporation, a deemed distribution may give rise to a potential second class of stock problem that could invalidate the S election, or perhaps the IRS might treat the deemed distribution as compensation subject to payroll taxes normally avoided by true S corporation distributions.

On the other hand, poorly documented amounts loaned to the corporation may be deemed instead by the IRS as a contribution to shareholder capital.  A contribution of capital cannot be repaid to the shareholder like a loan can be.  Instead repayments are treated as distributions to the shareholder with the applicable treatment depending upon the classification of the corporation.

In order to avoid these kinds of problems with shareholder—corporation loans, be sure to observe the following factors that have been considered by the courts when ruling on disputes between taxpayers and the IRS.  The main factor in determining whether the transaction is a loan for tax purposes is whether the parties intend for the money to be repaid.  Such intention should be contemporaneously evidenced as follows.

1.       Is there a promissory note or other written obligation promising repayment?

2.       Is adequate interest being charged?

3.       Has a fixed schedule for repayment and maturity date been established?

4.       Has collateral been given to secure repayment?

5.       Have repayments actually been made?

6.       Is there a reasonable prospect that the borrower can repay the loan?

Another factor to consider is this:  if the shareholder does not respect the separate existence and legal form of the corporation, will the corporate “veil” of limited liability be pierced if there is a third-party lawsuit, putting the shareholder’s personal assets at risk?