Abstract: Owners occasionally borrow funds from their
businesses. This article explains the importance of treating these transactions
as bona fide loans and charging an ÒadequateÓ rate of interest. It also
provides a list of factors the IRS considers when evaluating corporate advances
to shareholders.
How to
steer clear of tax issues related to shareholder loans
Owners occasionally need to borrow funds from
their businesses. If your business is structured as a corporation and it has
extra cash on hand, a shareholder loan can be a convenient and low-cost option
— but itÕs important to treat the transaction as a bona fide loan. If you
donÕt, the IRS may claim you received a taxable dividend or compensation
payment rather than a loan.
Taking a closer
look
A corporation can make de minimis loans of
$10,000 or less to shareholders without paying interest. But, if all of the
loans from the corporation 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 ÒadequateÓ rate of interest. Each month the IRS publishes its applicable
federal rates (AFRs), which vary depending on the term of the loan.
Right now, although interest rates are starting
to rise, theyÕre still near historic lows, making it a good time to borrow
money. For example, in July 2017, the adjusted AFR for short-term loans (of not
more than three years) was only 1.22% (up from 0.71% in July 2016). The rate was
1.89% (up from 1.43% in July 2016) for midterm loans (with terms ranging from more
than three years to not more than nine years).
The AFRs are typically below what a bank would
charge. As long as the corporation charged interest at the AFR (or higher), the
loan would be exempt from the complicated below-market interest rules the IRS
imposes.
The interest rate for a demand loan —
which is payable whenever the corporation wants to collect it — isnÕt
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, itÕs easier to administer a
shareholder loan with a prescribed term than a demand note.
Staying
under market
If a corporation lends money to a shareholder at
an interest rate thatÕs below the AFR, the IRS requires it to impute interest using
the below-market interest rules. These calculations can be complicated. The
amount of incremental imputed interest (beyond what the corporation already
charges the shareholder) depends on when the loan was set up and whether itÕs a
demand or term loan. There are also tax consequences for this imputed interest
to both the corporation and the shareholder.
Additionally, the IRS may argue that the loan
should be reclassified as either a dividend or additional compensation. The corporation
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.
Making it
bona fide
When deciding whether payments made to
shareholders qualify as bona fide loans, the IRS considers a variety of
factors. It assesses the size of the loan, as well as the corporationÕs history
of earnings, dividend payments and loan repayments. It also looks at the
shareholderÕs ability to repay the loan and power to make corporate decisions.
In addition, the IRS will factor in whether
youÕve executed a formal, written note that specifies repayment terms —
including the interest rate, maturity date and collateral.
Getting
started
Under the right circumstances, a shareholder
loan could be a smart tax planning move to make this
year. Contact our firm to help you set up and monitor your shareholder loans to
ensure compliance with the IRS rules.
© 2017