Key Takeaways

  • Loans from S corp shareholders must be properly documented to establish shareholder basis and avoid IRS reclassification as dividends.
  • Open account debt and formal note-based loans are treated differently for tax purposes.
  • Loan repayments can affect basis and trigger income if the basis is exhausted.
  • Shareholders must avoid using loan structures to inappropriately deduct losses or defer taxes.
  • The IRS may scrutinize loans lacking formal terms, especially if repayments are inconsistent or interest is not charged.

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.

Strategic Use of Shareholder Loans in Basis Planning

Loans-from-shareholders-s-corp can be a strategic tool for maximizing loss deductions, especially when a shareholder has already depleted their stock basis. However, taxpayers must structure these loans carefully to ensure the debt basis is recognized by the IRS.

Considerations for effective basis planning:

  • Structure the loan with a formal note if amounts exceed open account thresholds.
  • Keep separate documentation for each loan to avoid aggregation.
  • Prioritize repayments to loans with lower basis to preserve deductibility on others.

Repayments reduce debt basis and cannot create a negative basis. If losses are claimed against loans, those loans must remain outstanding. A repayment before the corporation becomes profitable again may trigger taxable income if the basis is reduced to zero.

IRS Scrutiny and Loan Recharacterization Risks

The IRS closely examines loans-from-shareholders-s-corp to ensure they are genuine debts, not equity disguised as loans. Red flags include:

  • Lack of a written agreement
  • No stated interest or repayment terms
  • Irregular or nonexistent repayment history
  • Subordination to other creditors

If the IRS determines the loan lacks economic substance or formal structure, it may reclassify the amount as a capital contribution or a distribution. This reclassification can have significant tax consequences, particularly if the S corp lacks earnings and profits, in which case it becomes a return of capital or taxable gain.

To reduce audit risk, shareholders and corporations should:

  • Draft a promissory note
  • Charge market-rate interest
  • Maintain a clear repayment schedule
  • Reflect the loan in the corporation's books

Formal Note vs. Open Account Loan Structures

S corporations must distinguish between formal note-based loans and open account debt. A formal note includes a written agreement that outlines terms like interest rate, maturity date, and repayment schedule. These details provide critical evidence that the loan was bona fide, supporting the shareholder’s debt basis and deductibility of losses.

In contrast, open account debt is informal, typically consisting of a series of advances and repayments without written instruments. IRS regulations limit this classification to a cumulative ceiling of $25,000. Amounts exceeding this must be reclassified and documented as a formal loan to count toward basis.

For tax purposes:

  • Formal note loans may qualify for capital gain treatment upon repayment.
  • Open account debt generally results in ordinary income upon repayment when basis is exhausted.

Failure to correctly categorize or document shareholder loans may result in the IRS recharacterizing the loan as a disguised distribution, which is taxable and non-deductible for the corporation.

Frequently Asked Questions

1. What qualifies as a valid shareholder loan in an S corp? A valid shareholder loan must be a bona fide debt with clear intent to repay. Ideally, it includes a written promissory note, a set interest rate, and a repayment schedule.

2. Can an S corp deduct interest paid on shareholder loans? Yes, interest paid on a properly documented shareholder loan is deductible as a business expense, provided the loan is considered genuine debt by the IRS.

3. How does repayment of a shareholder loan affect the shareholder’s basis? Loan repayments reduce the debt basis. If the basis is zero, any repayment is treated as taxable income—ordinary or capital gain depending on loan documentation.

4. What happens if a shareholder loan is reclassified as equity? If reclassified, the amount is treated as a capital contribution or dividend. This can eliminate deductions for the S corp and create unexpected tax liabilities for the shareholder.

5. Is it better to use formal notes for loans over $25,000? Yes. Loans above the $25,000 open account threshold must be formalized with documentation to count toward basis and avoid IRS reclassification.

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