Shareholder Loans to a Corporation

SHAREHOLDER LOANS TO A CORPORATION

Shareholders often loan money to a corporation in order to keep the business operating, but be aware there are rules and regulations, which must be adhered to, so the loan is treated as a loan, and not reclassified as an equity contribution. These rules can be quite complicated, but if the transaction is structured correctly, you can avoid these rules.

My discussion will focus on shareholder loans to a corporation and not loans from a corporation to a shareholder. I have referenced IRC code sections and regulations, not to confuse you, but for your reference.

The terms used below, Current Earnings and Profits (CE&P), Accumulated Earnings and Profits (AE&P), and Accumulated Earnings Tax (AET) are only applicable to "C" Corporations (Form 1120) or an "S" Corporation (Form 1120S) which was previously a "C" Corporation. If you have been an "S" Corporation since inception, these terms will not apply to you.

When a shareholder makes a loan to a corporation, the loan is classified as a Demand Loan or a Term Loan. Below is the formal definition of these:

Demand Loan - IRC Section 7872(f)(5) defines a demand loan as:

A loan that is payable in full at any time at the demand of the lender, or

To the extent defined by the regulations, a loan with an indefinite maturity.

Term Loan - IRC Section 7872(f)(6) defines a term loan as any loan that is not a demand loan.

Section 7872 - Below-Market Loans apply to:

a. Gift loans,

b. Employer-employee loans,

c. Shareholder-corporate loans, and

d. Tax avoidance loan.

When a shareholder makes a loan to a corporation it is classified as a below-market loan (Section 7872). Section 7872 is quite burdensome and there are two ways to escape the aggravation of this treatment:

1. $10,000 de minimis rule. Under the $10,000 de minimis rule, an interest calculation is not required.

2. The corporation or shareholder charges at least the AFR (Applicable Federal Rate). With today"s low AFR rates, taxpayers should consider rewriting demand loans as term loans to lock in the low rate.

With this in mind, let?s discuss the tax differences of using debt versus equity. There are many tax differences between a corporation issuing stock versus debt to its shareholders.

Debt repayment by the corporation is not an earnings distribution to the shareholder, and therefore it is tax-free.

Dividend distributions are not deductible by the corporation, whereas interest payments are deductible by the corporation [Section 163].

Dividend distributions are taxable to the shareholder to the extent of the corporation's current or accumulated earnings and profits [Section 301 (c)(1)]. Distributions in excess of earnings and profits are not taxed, and are treated as a return of capital to the extent of the shareholder's basis in the corporation's stock [Section 301 (c)(2)]. Distributions in excess of the shareholder?s stock basis are taxed as a capital gain [Section 301 (c)(3)], if the stock is held as a capital asset and if the corporation is not a collapsible corporation (Section 341). Interest payments are always fully taxable to the recipient shareholder [Section 61 (a)(4)].

The presence of debt may allow the corporation to accumulate earnings without subjecting itself to an accumulated earnings tax (Section 531).

If the issuing corporation's debt becomes worthless, the debt holders' loss may be ordinary or capital depending on whether the debt is a business or nonbusiness bad debt (Section 166). If the corporation?s stock becomes worthless, a shareholder is generally entitled to a capital loss [Section 165(g)(3)]. For some small business corporations (Section 1244), an ordinary loss deduction may be available.

If the IRS recharacterizes a purported loan from a shareholder to be a capital contribution the following would happen:

The corporation loses its interest deduction (reclassified as a distribution)

Principal payments thought to be tax-free to shareholders become taxable dividend income (provided sufficient earnings and profits exist).

If the corporation has no current or accumulated earnings and profits, the payments to shareholders will be first a return of capital, then capital gain if basis is exceeded.

The debt versus equity question is one of the oldest in taxation, and the courts have ruled many times on this issue. No single factor decides the case, but the table below presents a few of the factors considered in the debt/equity disputes along with the indication that each attribute produces:

Considerations in Capitalizing a Corporation

Response Indicates

Question Equity Debt

a. Is there a formal promissory note? No Yes

b. Is there a fixed obligation to pay interest? No Yes

c. Are there regular and timely payments

of interest? No Yes

d. Is the debt/equity ratio no more than four to

one (thin capitalization)*? Yes No

Watch proportionality of debt to equity

by the same person.

e. Is debt payment contingent on profits? Yes No

*Some courts have allowed much higher ratios.

Proportionality refers to the ratio of the debt and equity held by the same persons. If the debt is owed to shareholders in precisely the same ratios as stock, there is increased risk that the IRS will attempt to recharacterize debt as disguised equity. Proportionality alone is not determinative, particularly in a closely-held environment. This would be true in a wholly-owned environment in which the proportionality of equity to owner debt is by definition 1:1.

When it is determined that a bonifide debt is present, but there is insufficient interest, this insufficient interest is called foregone interest, and this amount is deemed transferred between the borrower and the lender on a given date as if it were cash. The shareholder lenders' consequences of a deemed cash payment of foregone interest under the below-market loan rules are:

The shareholder is deemed to have contributed capital to the corporation in the amount of the foregone interest.

The corporation is deemed to have immediately re-transferred the same amount to the shareholder. The result is an interest deduction to the corporation, interest income to the shareholder (1099 required).

For Demand Loans, foregone interest is deemed to have been paid each December 31 (for each year the loan is outstanding).

In other words, each December 31^st (regardless of fiscal year), the corporation has a deemed capital contribution followed immediately by a deemed interest payment to the shareholder. (Again, 1099 required). Note - the taxpayer's basis in stock is increased by the amount of the deemed capital contribution.

If we have determined that IRC Section 7872 applies, there are some reporting requirements. Both the lender and borrower must attach a statement to their respective returns for each year the interest income is imputed, or an interest deduction is claimed, with the following components:

1. An explanation that the statement relates to amounts imputed under IRC 7872.

2. The name, address and taxpayer ID of each borrower if the statement is for the lenders return, or of each lender if for the borrower's return.

3. The amount of imputed interest income (or deduction) and its character (i.e., compensation, dividend, etc.).

4. Mathematical assumptions utilized (i.e., 360-day calendar year).

The IRS uses a Market Segment Specialization Guide when conducting audits. Below is the guide used for Manufacturers, but could also apply to other industries:

Market Segment Specialization Guide - Manufacturers

Loans to/from Shareholders

During the initial interview, inquire as to the existence of loans and the taxpayer's policies with respect to the loan, repayments, interest rates, and collateral.

Review the corporate balance sheet for the existence of loan accounts either to or from the shareholder. No entry on the balance sheet for shareholder loan accounts does not mean there are not outstanding loan balances. In several cases, the shareholder loans were included in asset and liability accounts other than the normal loans to/from shareholder account. Once the existence of a shareholder is established, the concern is whether the loans are length transactions (that is, length of loan, interest rate, etc.). The shareholder could be receiving an interest-free loan. They may be taking money out of the company tax-free, through forgiveness of the loans by the corporation at a later date. Request copies of the loan documents. If loan documents exist, they should show the terms which you can then validate. If loan documents are not available, review the corporate minutes for possible mention of and the details of the loans.

In regards to interest generated by a loan from a shareholder, inspect the payable accounts for a possible write-off of the interest owed the shareholder which has not been paid. IRC Section 267 (a)(2) states the corporation and the shareholder (who must hold a greater than 50 percent interest in the company either directly or by attribution) will be put on the same basis of accounting, usually cash basis, to determine when a write-off is allowed, even though one is an accrual basis and the other is cash basis. In simpler terms, the corporation is allowed a deduction when the interest is paid, not when accrued. If the corporation has accrued the expense, inspect the Schedule 1 M-1 to determine whether the amount has been backed out for tax purposes.

In Summary - The question to ask yourself is, can you go to a bank and borrow money without signing a note which states an interest rate and repayment terms? The answer is NO! To avoid these rules all that needs to be done is:

1. When loaning money to a corporation, draw a note which states an interest rate (which is at least equal to the AFR) and repayment terms.

2. Make regular payments to the shareholder the same way you would make to a third party (i.e. house or car loan).

3. If there is not sufficient cash to repay the note or interest, the foregone interest rules described above must be followed.