Updated October 29, 2020:

Loans from shareholders S corp must follow all rules and regulations to be legal. A financial advisor or CPA should use caution when advising their clients on loans provided by shareholders to S corporations

How Do Loans From Shareholders Work?

One of the reasons this practice can cause issues is the fact that repayment of the loan could generate taxable income that the shareholder wasn't expecting. A shareholder in a private corporation could choose to provide a loan to the business to generate more working capital and improve the liquidity of the corporation. The shareholder's initial basis is the face value of the loan provided.

An S corporation can pass business losses through the business to its shareholders, which they can then deduct based on the adjusted loan and stock basis. If a loss is passed through to the shareholder exceeds their basis of stock, any amount in excess will reduce the loan basis. However, this number cannot drop below zero. When net income is passed through to the shareholder during a later year, the first increase should occur on the loan basis. However, the amount of increase shouldn't exceed the amount the shareholder was in debt when the tax year started.

After increasing the loan basis, the next step is using extra net income to increase the stock basis of that shareholder. If a shareholder has given more than one loan to the corporation, with evidence of separate notes, or other cases of multiple indebtedness apply, different rules would be applied to the situation. Single loans, with or without notes that provide evidence of the loans, are less complex.

Open Account Debt

If the shareholder doesn't provide a note, the loan is then classified as open account debt. A definition of this type of debt is found in Regs. Sec. 1.1367-2(a). The definition states that any advances given by shareholders to the corporation are open account debts if there is no evidence of repayment or written instruments. If the corporation repays the debt partially or in full, the loan basis of that shareholder would be reduced. However, that only applies to cash payments. Repaying a loan with anything aside from cash does not reduce the loan basis in a narrow scope. 

In the case that the shareholder's debt basis has already been reduced down to nothing, all repayments are handled as taxable income. According to Rev. Rul. 68-537, all repayments are allocated between the returns of income and basis in the case of a reduced loan basis. The income's character is determined by the presence of a written note, which gives evidence of the loan. 

Typically, repaying the loan to the shareholder isn't considered to be the exchange or sale of a capital asset, so the income it produces is considered to be ordinary. The exception is if the loan has a written note as evidence. In this case, any income generated by the repayment is classified as a capital gain because the notice becomes a capital asset of the shareholder. This rule is outlined in Rev. Rul. 64-162. Standard rules apply to determine whether capital gains are short-term or long-term. 

For example, a business called Jones' Corporation needs $20,000 to pay employee bonuses and other important expenses at the end of its first year of operation. One of the shareholders intended for the corporation to borrow money from a bank but was unable to complete the process of obtaining funds before the year ended. 

This shareholder chooses to provide a loan to the corporation with the expectation that Jones' Corporation will apply for and finalize a loan from a bank and use the funds to repay the loan within a week. Since this loan has no note, it would be considered open account debt. On January 4, the first business day of the second year of operation, Jones' Corporation receives its loan from a bank and repays the loan given by the shareholder. 

This shareholder's loan basis would increase to the extent of the loan balance at the end of year two for the income that passed through the business. The extent of the loan balance would be applicable at the start of the second year.

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