By: John S. Morlu II, CPA
In the world of small businesses, cash flow challenges are common. Sometimes, a business owner may need immediate cash for personal or business expenses. In such situations, the owner might consider borrowing money from their company. Conversely, a business owner may choose to loan money to their business if the company is in need of funds. This strategy could create additional cash flow for the owner in the form of loan repayments in the future. Furthermore, the business may be able to deduct the interest paid on the loan, making it a potentially advantageous financial move.
However, loans between an owner and a business must resemble legitimate loan transactions. This means they must be structured with terms and conditions similar to those that would be available in an open market transaction. If the Internal Revenue Service (IRS) reviews such a loan and determines it does not meet these standards, the tax consequences can be severe. This applies to loans whether they are from the business to the owner or vice versa.
Loans to Shareholders
Overview:
When a corporation lends money to a shareholder, it can allow the shareholder to access corporate funds without immediately triggering income or employment taxes. However, this type of loan must be carefully structured to mimic a real loan between unrelated parties.
If the terms of the loan are unusually favorable to the shareholder (such as no interest or lenient repayment terms), the IRS may reclassify the loan. Depending on the nature of the transaction, it might be treated as a dividend, a salary payment, or another type of distribution, all of which have different and potentially higher tax consequences.
Legal Precedent:
In the case Gilbert v. Commissioner, 248 F.2d 399, 402 (2nd Cir. 1957), the court provided a definition for debt:
“Classic debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof.”
This means that for a loan to be considered valid, it must have specific terms, including an agreed-upon repayment schedule, a set interest rate, and a maturity date.
Factors Considered by the IRS:
When determining whether a loan to a shareholder is legitimate, the IRS examines various factors, such as:
- Written Documentation: Is there a formal loan agreement or promissory note? Does it include:
- A stated interest rate comparable to market rates?
- A clear repayment schedule?
- Security or collateral?
- Corporate Approval: Did the corporation approve the loan through proper channels, such as a board resolution or meeting minutes?
- Shareholder’s Control: Does the borrowing shareholder have significant control over the corporation?
- Ownership Proportion: Are loans made to shareholders in a way that reflects their ownership percentages? If so, this might suggest the loan is more like a dividend.
- Dividend History: Has the corporation paid dividends in the past? If the company is profitable but avoids paying dividends while making loans, this could indicate that the loans are actually disguised dividends.
- Repayment Pattern: Are loan repayments being offset by new loans, creating a revolving debt without clear reduction of the balance?
- Shareholder’s Ability to Repay: Does the shareholder have the financial capacity to repay the loan?
Best Practices:
To ensure a loan is recognized as legitimate, it is important to:
- Execute a written note that outlines clear, commercially reasonable terms.
- Adhere to the agreed-upon terms, including timely repayments.
- Ensure the transaction is properly documented and approved by the corporation.
Tip: Borrowing from Retirement Plans
For shareholders who need a modest amount of cash, borrowing from a qualified retirement plan can be a viable alternative. However, such loans must comply with strict rules under Section 4975(d)(1). Generally, loans from retirement plans are limited to:
- 50% of the account balance, or
- A maximum of $50,000, whichever is less (Section 72(p)(2)).
Loans from Shareholders
Overview:
Shareholders may also choose to lend money to their corporation. In these cases, the IRS will scrutinize whether the loan truly represents debt or if it is actually a capital contribution to the company.
Key Considerations:
Similar factors apply here as with loans to shareholders, but with additional emphasis on the corporation’s ability and intent to repay the loan. Specific points of focus include:
- Source of Repayments: Are repayments independent of the company’s earnings?
- Management Participation: Does the loan give the shareholder additional control or management rights?
- Debt Status: How does the shareholder’s loan compare to loans from outside creditors?
- Equity vs. Debt: Do the loan terms resemble equity interests?
- Adequate Equity: Does the company have sufficient equity in its capital structure?
- Outside Credit: Could the corporation have obtained similar funding from external sources?
- Use of Funds: What purpose was the loan used for?
- Risk Level: Was the loan made under conditions that reflect a significant risk?
Loans to and from Partners
In partnerships, loan transactions between the partnership and individual partners are allowed, even though partnerships are often seen as a group of individuals running a business together. Under Section 707 of the tax code, these transactions are treated as if the partner is not acting in their capacity as a partner.
IRS Guidelines:
The regulations specify that the substance of the transaction will take precedence over its form. This means that, for tax purposes, the transaction must be evaluated based on its actual economic characteristics rather than how it was labeled or recorded.
Summary: Loans to and from Business Owners
Establishing the validity of a loan between an owner and a business entity requires thorough documentation and adherence to proper terms. Every relevant detail of the transaction is taken into account, and no single factor is decisive.
At a minimum, business owners should:
- Execute a written note with commercially reasonable terms.
- Set a repayment schedule that does not depend on the earnings of the business.
- Ensure the transaction is properly documented and approved.
By following these guidelines, business owners can reduce the risk of having their loans reclassified by the IRS, which could lead to significant tax consequences.
Author: John S. Morlu II, CPA
John S. Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
