Key Takeaways

  • Loans between S corporations and shareholders must follow IRS guidelines to avoid being reclassified as taxable income or distributions.
  • Formal documentation, including promissory notes with stated interest and repayment terms, is essential to establish the loan’s legitimacy.
  • Shareholder loans can impact basis and deductibility of losses; planning can help maximize tax benefits.
  • Open account debt is treated differently than formal notes and has limitations on basis increases.
  • S corporations must avoid "constructive dividends" by ensuring loans to shareholders are bona fide and not attempts to skirt payroll or distribution rules.
  • Repayments of loans without basis can be taxed as income or capital gains, depending on how the loan was structured.
  • Shareholder repayments must be substantiated to avoid IRS scrutiny; records should be kept for the loan's purpose, payment schedule, and interest accrued.

Loans to shareholders S corp helps the shareholders when a shareholder needs funds and there's not enough time to get a bank loan. The shareholder can also put money into the corporation when it needs an infusion of cash, but the corporation has to be diligent in repaying the loan so as to avoid incurring taxes for that shareholder.

Basics of an S Corporation Loan

Sometimes an S corporation is short on funds and needs a fast cash infusion. A loan from a bank may not be a viable option, but a shareholder can choose to fund the business out of their own pocket. The benefit of making a loan comes in the form of getting the money repaid without the need to disburse money to other shareholders. However, repayment of the loan has to be handled carefully as it can cause the shareholder to be responsible for taxes on that income. 

The S corporation has the option to pass through losses to the owners. This can be deducted by shareholders to the total amount of their adjusted stock and loan basis. In the event the pass through is more than the shareholder's stock basis, the excess amount of the loss reduces that shareholder's loan basis, but it can't be lowered below zero. 

Here's a potential scenario: an S corporation needs an influx of capital, but the shareholders were too busy to obtain a loan and a critical payment is upcoming. One of the shareholders gives the S corporation a personal loan on the expectation that the corporation will get a loan in the near future and repay the shareholder within a short period of time. Because there is no bank note, the loan is considered to be an open account debt. In the event the corporation passes through net income in a following year, the loan basis is increased, but only to the amount that the company owes the shareholder at the beginning of the tax year. 

If the loan basis is reduced to zero and the entire loan is repaid, the repayment becomes income to the shareholder even though it's a loan repayment. This is due to the fact that the loan has no note and is considered an open account debt. 

Documenting the Loan Properly

To be treated as a legitimate loan rather than a distribution or taxable income, the transaction between the S corp and the shareholder must be documented clearly and thoroughly. This includes:

  • A written promissory note
  • A fixed repayment schedule
  • A stated interest rate that meets IRS minimums
  • Collateral, where appropriate
  • Regular payments consistent with loan terms

Failure to properly document the loan may result in the IRS reclassifying it as a dividend or compensation. This can lead to unexpected tax liabilities for the shareholder and payroll tax issues for the S corp.

Open Account Debt vs. Written Notes

S corporation loans to shareholders may fall into one of two categories:

  1. Open Account Debt: This involves smaller, informal advances typically under $25,000. These loans may lack written terms but are still subject to IRS scrutiny and must not resemble disguised distributions.
  2. Written Debt Instruments: Loans formalized with promissory notes and repayment terms are more likely to be respected by the IRS. Written notes support basis increases for shareholders, making them preferable for tax planning purposes.

It's essential to monitor the balance of open account debt. If it exceeds $25,000 at year-end, the IRS may require it to be reclassified or formally documented.

Preventing a Loan Payment From Being Considered as Income

If the company anticipates an inability to repay the lending shareholder or there's a pass through loss, that shareholder should create a note for their debt. This way, subsequent debt payments are treated as capital gain instead of regular income and taxed at a lower rate. Another alternative is making the corporation wait to repay the shareholder debt until there is a year with positive net income to restore most or all of the loan basis. Or the shareholder can take out a personal loan that's separate from the business and avoid repayment from the corporation in a year that shows a loss. 

Tax Consequences of Improper Classification

If the IRS determines that a loan to or from a shareholder is not bona fide, it may reclassify the transaction, triggering:

  • Constructive dividends: Taxed as income to the shareholder, without a corresponding deduction to the S corporation.
  • Compensation: Subject to payroll taxes if the shareholder provides services to the S corp.
  • Capital contributions: If reclassified as equity, repayments may not be deductible or returnable without tax impact.

The IRS evaluates several factors, including whether there’s a real expectation of repayment, an enforceable obligation, and consistent treatment in corporate records.

S Corporation Shareholders and Distributions

In the event an S corporation is not paying what is considered to be a reasonable salary to a shareholder who provides their services to the corporation, any distributions to that shareholder may be considered wages which are subject to payroll taxes. One way around this potential classification is lending corporate monies to the shareholder and avoid the double-taxation problem that comes with dividends. 

Defining distributions as loans avoids taxable distributions when a shareholder wants to take cash from the corporation and other accounts don't have enough money to allow a nontaxable distribution. But this loan has to be an actual loan in order to avoid a constructive dividend. And it has to have an adequate interest rate to avoid being considered as dividends per the below-market loan rules of Sec. 7872 under the U.S. Code Title 26. 

Sometimes a loan is viewed as a disguised distribution by the IRS. A corporation has to respect shareholder loans as being true and actual or risk problems that include:

  • Loan being re-characterized as a distribution and causing distributions to be disproportionate
  • Payments to a shareholder for an outstanding loan could be considered an equity investment and payments considered as distributions

Indicators of a Bona Fide Shareholder Loan

To withstand IRS scrutiny, an S corp loan to shareholder should demonstrate:

  • Written agreement: Including terms of repayment and interest
  • Interest payments: At or above the Applicable Federal Rate (AFR)
  • Repayment history: Evidence that prior loans were repaid as agreed
  • Debt-to-equity ratio: The corporation's financial health should support lending
  • Intent to enforce: The S corp must act like a creditor, not an equity investor

Even if all indicators are not met, the totality of circumstances will determine IRS treatment.

When Shareholders Loan Money to the S Corporation

Shareholders often provide funding to S corps as loans to keep operations running. This can be beneficial if:

  • The corporation lacks credit history to obtain external financing
  • The shareholder wants to retain equity position without dilution
  • Interest payments provide a return to the shareholder

However, shareholders must track loan basis accurately. Loan repayments exceeding basis can be taxed, so timing and documentation are critical. Basis in shareholder loans is only established if the shareholder makes an actual economic outlay—merely guaranteeing a loan does not create basis.

Tax Planning Opportunities Using Shareholder Loans

Structuring shareholder loans properly can unlock valuable tax planning benefits:

  • Deductibility of losses: Shareholder loans can increase basis, allowing the deduction of S corp losses.
  • Deferral of distributions: Loans can provide funds without triggering taxable dividends if structured properly.
  • Capital gain treatment: Repayment of reduced-basis loans may qualify for lower long-term capital gain tax rates.

It's wise to coordinate shareholder loan arrangements with annual tax planning. Consult with a tax attorney or CPA to determine the optimal structure and timing.

Frequently Asked Questions

1. What qualifies as a legitimate S corp loan to shareholder?A legitimate loan has written terms, interest, a repayment schedule, and is treated as a debt in the company’s books.

2. Can a shareholder deduct losses if they loan money to the S corporation?Yes, shareholder loans can increase basis and allow for the deduction of passthrough losses—if the loan represents an actual economic outlay.

3. What happens if a loan repayment exceeds the shareholder’s basis?Repayments exceeding basis may be treated as income, potentially taxable as capital gains or ordinary income depending on the structure.

4. How does the IRS distinguish between a loan and a distribution?The IRS examines documentation, repayment terms, interest, and whether the parties behave as debtor and creditor.

5. Are there limits on how much a shareholder can loan to an S corp?There are no statutory limits, but excessive or undocumented loans may raise red flags. Loans over $25,000 often require formal treatment.

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