Key Takeaways

  • Borrowing money from your corporation can be done through a shareholder loan, but it must follow IRS guidelines to avoid being classified as taxable income.
  • The loan should be properly documented with a promissory note, interest payments, and a repayment schedule.
  • Loans that are not repaid within a set timeframe (usually within one year of the company's fiscal year-end) may be considered taxable income.
  • The IRS closely examines shareholder loans to ensure they are not disguised dividends or compensation.
  • Alternatives to borrowing from your company include salaries, dividends, and traditional business loans.
  • Proper documentation and adherence to IRS rules are essential to prevent audits and penalties.
  • Consulting a business attorney or tax professional can help ensure compliance and minimize tax risks.

Borrowing money from your own corporation allows you to collect more than your normal salary or dividends at a tax-free rate. However, you can't just take as much money as you want. You need to follow specific tax rules.

Understanding Shareholder Loans

The first step in borrowing money from your corporation is to record the amount in your books as a shareholder loan. A shareholder loan must be paid back within a year of the corporation's year-end. Otherwise, the money will be added to your personal taxable income, meaning you'll have to include it when filing your taxes.

An example of this is if you borrowed $10,000 from your company in 2012. If your company's year ended on December 31, 2012, you would have until December 31, 2013, to pay back your loan. If for some reason you were unable to, the amount you borrowed would be added to your personal income for 2012.

Therefore, as long as you time your borrowing right, you can avoid paying the money back for more than a year. Just be careful not to pay off the shareholder loan with another loan. This can put your personal income at risk.

Shareholder Loans vs. Compensation: What’s the Difference?

When withdrawing money from your company, it is crucial to distinguish between a shareholder loan and other forms of payment:

  • Shareholder Loan: A temporary loan from the company that must be repaid with interest and documented properly.
  • Salary or Bonus: Taxable income subject to payroll taxes.
  • Dividend Distribution: A taxable payment from company profits to shareholders.
  • Expense Reimbursement: If the company repays a business-related expense, it is not taxable income but must be substantiated with receipts.

To ensure your withdrawal is treated as a loan rather than compensation or dividends, you must:

  • Sign a formal loan agreement with a repayment schedule.
  • Pay interest at or above the Applicable Federal Rate (AFR) to avoid tax issues.
  • Record the loan correctly in your corporate books.

If the loan is informal or lacks documentation, the IRS may reclassify it as taxable income.

Exceptions to the One-Year Limit

Thanks to the Income Tax Act, there are a few exceptions to the one-year limit for borrowing money from your corporation. These include using the loan to buy:

  • A home for personal use.
  • Shares of the corporation.
  • A car used for work purposes.
  • Items directly from the business via trade debt.

Of course, these need to be legitimate purchases. You cannot just lie and say you are buying these items and then use the money for something else. Additionally, you will still be charged interest at a predetermined rate.

One other important factor is that the loan must be provided to you as part of your employment, not because you're a shareholder. This means that other, non-shareholder employees should have access to these same types of loans. Of course, this can become tricky if you are in charge of a single owner-managed business where you have only ever paid yourself dividends.

When Can a Shareholder Loan Be Tax-Free?

Certain shareholder loans may qualify for tax-exempt treatment under IRS regulations, but strict conditions apply:

  • The loan must be issued in the ordinary course of business and not as a disguised way to withdraw corporate profits.
  • It should have a clear business purpose, such as funding operational expenses, working capital, or investment in assets.
  • The borrower must make regular repayments to avoid the loan being considered taxable income.
  • The company should offer similar loan terms to other employees or shareholders to avoid IRS scrutiny.

If these conditions are not met, the IRS may treat the loan as a constructive dividend or compensation, making it subject to personal taxes.

What Happens if the IRS Investigates?

In many cases, the IRS will audit your return once they notice you have taken out a shareholder loan. They will be looking to see if you are trying to disguise your wages or a dividend. That is why you should always be cognizant of when the IRS may look at your return so you can structure your loan appropriately. The process typically goes like this:

  • The IRS will investigate your relationship to the organization. If you are the company's only shareholder and completely control your earnings, that definitely weakens your argument that the loan is valid. The IRS will be less likely to question your loan if you are one of several shareholders in the company (and the only one who has received such a loan).
  • After this, the IRS will investigate the details of the loan. Generally, the more businesslike the loan appears, the less the IRS will poke around. They check to see if:
    • You signed a formal promissory note.
    • You pledged security against the loan.
    • You are paying interest.
    • You set a maturity date or repayment schedule for the loan.
    • You have missed any repayments.
    • Your company has tried to collect any overdue funds.
  • There are a few other questions the IRS will ask to further prove your loan is genuine:
    • Are you receiving a salary that is standard for work in your industry?
    • Is the loan you've taken out repayable based on your salary?
    • Are you receiving dividends from your company?
    • Is the loan comparable to the profits the company is making?

After looking at these factors, the IRS does have the ability to reclassify your loan as a distribution or dividend if they see fit. If this happens, the loan will not be deductible for your corporation.

Common IRS Red Flags in Shareholder Loans

The IRS carefully examines shareholder loans to ensure they are genuine and not disguised as tax-free withdrawals. The following situations may raise red flags:

  • Lack of Documentation: If there is no signed promissory note, repayment schedule, or stated interest rate, the IRS may argue that the loan is actually a dividend or salary.
  • No Repayment History: If the company regularly loans money to a shareholder without repayments, the IRS may reclassify it as income.
  • Below-Market Interest Rates: If the loan carries an interest rate below the Applicable Federal Rate (AFR), the IRS may impute additional taxable income.
  • Loans to Majority Owners Only: If only controlling shareholders receive loans, and no other employees or shareholders are eligible, it raises concerns about preferential treatment.
  • Loans Written Off as Bad Debt: If a company forgives a shareholder loan without repayment, it is considered taxable income to the borrower.

To avoid these issues, ensure that all loans comply with IRS guidelines and maintain clear financial records.

How to Avoid Penalties From the IRS

As long as you observe specific formalities when taking out your loan, the IRS should not penalize you with the distribution or dividend treatment. You'll want to:

  • Document the withdrawal as a loan and create a promissory note.
  • Set interest at the federal rate and provide collateral if necessary.
  • Record the transaction on your company's books.
  • Repay in accordance with the guidelines set by the promissory note.

Best Practices for Structuring a Shareholder Loan

To ensure a shareholder loan is legally compliant and tax-efficient, follow these best practices:

  1. Draft a Formal Loan Agreement – The agreement should outline the loan amount, interest rate, repayment terms, and any collateral.
  2. Charge an Interest Rate at or Above the IRS Minimum – Using the Applicable Federal Rate (AFR) helps avoid the loan being treated as a gift or disguised income.
  3. Establish a Repayment Plan – Monthly or quarterly payments should be made on schedule and properly recorded.
  4. Avoid Rolling Over Loans Indefinitely – If you consistently borrow without repayment, the IRS may classify the transactions as dividends.
  5. Ensure the Loan is Properly Recorded in Financial Statements – The company should reflect the loan as an asset and track repayments to avoid compliance issues.
  6. Use Loans for Business Purposes Where Possible – If the funds are used to support company operations, they are less likely to be questioned.

Following these steps will help protect against IRS audits and penalties.

FAQ Section

Q1: Can I borrow money from my company without paying taxes?A: If structured as a legitimate loan with proper documentation, interest payments, and a repayment plan, the loan can avoid immediate tax implications. However, if the IRS determines it to be a disguised dividend or salary, it will be subject to taxes.

Q2: What happens if I don’t repay a shareholder loan?A: If the loan is not repaid within the required timeframe (usually within a year after the company’s fiscal year-end), the IRS may classify it as taxable income, resulting in tax liabilities.

Q3: Can my company offer me a low-interest or interest-free loan?A: The IRS requires shareholder loans to have an interest rate at or above the Applicable Federal Rate (AFR). If the rate is too low, the difference may be considered taxable income.

Q4: Are there alternatives to borrowing money from my corporation?A: Yes. Instead of a loan, you might consider increasing your salary, taking dividends, or securing external financing through a business loan or line of credit.

Q5: Should I consult a professional before taking a shareholder loan?A: Yes. A tax attorney or CPA can help structure the loan correctly, ensure compliance with IRS rules, and determine the most tax-efficient way to access company funds.

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