How to Avoid Tax Pitfalls when Making Corporate Loans to Shareholders
Interest rates have increased substantially over the last two years. While rates are still reasonable compared to historical levels, shareholders may decide to take out loans from their companies, rather than pay higher interest rates on bank loans. When doing so, it’s important to follow the tax rules to avoid adverse consequences for the borrower (you) or the lender (your corporation).
In general, the IRS expects closely held corporations to charge interest on related-party loans, including loans to shareholders, at rates that at least equal so-called applicable federal rates (AFRs). Otherwise, adverse tax results can be triggered. Fortunately, the AFRs are significantly lower than the interest rates charged by commercial lenders.
The Basics
It can be advantageous for you to borrow money from your closely held corporation. You can obtain needed cash without triggering a federal income tax bill and then use the money to pay personal expenses. These expenses may include your child’s college tuition, home improvements, or high-interest credit card debt and car loans. But you should avoid the following two key pitfalls:
1. Failure to create a bona fide loan. When borrowing money from your corporation, it’s important to establish a bona fide borrower-lender relationship.
5 Best Practices for Shareholder Loans
When borrowing money from your closely held corporation, adhere to the following five guidelines to fend off IRS challenges that the loan proceeds are disguised compensation or dividends:
- Draft a formal written loan agreement that establishes the shareholder’s unconditional promise to repay the corporation a fixed sum, according to an installment repayment schedule or on demand by the corporation. The loan agreement should give the corporation the legal right to enforce payment of principal and interest.
- Charge interest on the loan at a rate that’s at least equal to the applicable federal rate (AFR). This will avoid unpleasant tax surprises and compliance hassles under the below-market loan rules (see “Below-Market Loan Rules,” below).
- Record a loan receivable from the shareholder on the company’s balance sheet and interest paid by the shareholder as income on the company’s income statement. (Likewise, the shareholder’s personal balance sheet should show a loan payable to the corporation.)
- Document in corporate minutes a summary of the terms of the loan and authorization of the borrowing by corporate officers. Corporate minutes should also include evidence that, at the time the loan was made, the borrowing shareholder was financially capable of repaying the loan. In appropriate circumstances, the company should obtain adequate collateral for the loan.
- Keep records to show that loan principal and interest payments from the borrowing shareholder to the lending corporation are made on schedule. If timely payments become impossible, the loan agreement should be amended to reschedule payments before they’re late.
Taxpayers that are audited on related party loans rarely lose in the U.S. Tax Court when meaningful amounts are repaid on time, but they rarely win when the opposite is true.
If you don’t, the IRS could reclassify the loan proceeds as additional compensation to the shareholder. This reclassification would result in an income tax hit for you and payroll tax hits for you and your company. However, the company would be allowed to deduct the amount treated as compensation and the company’s share of the related payroll taxes.
Alternatively, the IRS might claim that the borrower received a taxable dividend if your company is a C corporation. That position would trigger taxable income for you with no offsetting deduction for your company.
2. Failure to charge adequate interest. The minimum rate of interest your company should charge to avoid triggering the complicated and generally unfavorable below-market loan rules is the IRS-approved AFR. (See “Below-Market Loan Rules,” below.) However, there’s an exception to the below-market loan rules if the aggregate loans from the corporation to a shareholder are $10,000 or less.
Important: When the interest rate at least equals the AFR, your company avoids the unfavorable below-market loan rules, and you receive a favorable interest rate compared to the rates charged by your local bank.
Close-Up on AFRs
The IRS publishes AFRs each month based on current market conditions. For loans made in March 2024, the AFRs are as follows:
- 4.62% for short-term loans of up to three years,
- 4.06% for mid-term loans of more than three years but not more than nine years, and
- 4.31% for long-term loans of over nine years.
These annual rates assume monthly compounding of interest.
The AFR that applies to a shareholder loan depends on whether it’s a demand loan or a term loan. A demand loan is payable in full at any time upon notice and demand by the company. A term loan is any borrowing arrangement that isn’t a demand loan. The AFRs for term loans depend on the term of the loan, and the same rate applies for the entire term.
To illustrate, suppose Nancy borrows $100,000 from her corporation in March 2024 with principal to be repaid in installments over 10 years. This is a term loan of over nine years, so the AFR would be 4.31% compounded monthly for the entire 10-year term. The corporation must report the interest on Nancy’s loan as taxable income.
On the other hand, if the loan document gives Nancy’s corporation the right to demand full repayment at any time, it’s a demand loan. In this case, the AFR is based on a blended average of monthly short-term AFRs for that year. If rates go up, she’ll have to pay more interest to stay clear of the unfavorable below-market loan rules. If rates go down, she’ll pay a lower interest rate. In any case, the corporation must report the interest on Nancy’s loan as taxable income.
The tax-law distinction between term and demand loans is important. A term loan locks in one AFR, based on the date the loan is taken out, for the entire loan term.
Important: Term loans for more than nine years are smarter from a tax perspective than short-term or demand loans because they lock in rates at the current AFR. If rates suddenly plummet, a high-rate term loan can be repaid early, and you can enter into a new loan agreement with your corporation that charges interest at the current AFR.
For More Information
Shareholder loans can become complicated, especially when the loan charges interest below the AFR, when the shareholder stops making scheduled payments or when the corporation has more than one shareholder. It’s important to work with your tax advisor to avoid adverse consequences and determine what’s right for your situation.
Below-Market Loan Rules
When a corporation loans money to a shareholder at what the tax law considers an inadequate interest rate — meaning below the applicable federal rate (AFR) — additional interest generally must be “imputed” under the below-market loan rules set forth in the federal tax code.
The imputed interest amount is first deemed to be transferred from the lending corporation to the borrowing shareholder as either salary or a corporate distribution. When the imputed amount represents additional compensation, the borrower has taxable income, and federal payroll taxes are owed. When the imputed amount represents a corporate distribution, it may constitute a taxable dividend (taxable income to the shareholder without any deduction for the corporation).
The same imputed amount is then deemed to be re-transferred from the shareholder back to the corporation as interest paid on the loan. Imputed interest income must be reported as additional taxable income on the corporation’s return. The shareholder may or may not be able to deduct the imputed interest expense, depending on how the loan proceeds are used.
Calculations to determine the exact amount of imputed interest and the exact timing of deemed transfers between corporation and shareholder depend on whether the loan is a demand loan or a term loan. These calculations can be complicated.
You can avoid these tax hassles if the corporation charges interest on the loan at a rate that’s at least equal to the AFR.
Copyright 2024
This article appeared in Walz Group’s March 25, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.
