It’s typical for business owners to seek to get capital out of their businesses with as little tax effect as possible.
In the context of an S corporation, this often looks like a shareholder-employee trying to set their salary as low as possible but still ensuring that it is considered “reasonable.”
But it can also look like a shareholder-employee of an S corporation getting a bit more creative with their tax strategy and asking whether they canborrow money from their S corporation.
I admire the creative thinking here — after all, apart from the interest paid on them, loans don’t create a taxable event…do they?
Book a Free Call: I’m a CPA with “Big 4” tax experience. If you’re interested in working with my firm on your S corporation tax matters, email me at [emailprotected].
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Can an S Corporation Make a Loan to a Shareholder?
Yes, an S corporation can make a loan to a shareholder.
However, there are pitfalls that you should consider before putting together such an arrangement.
Documenting the Loan
It’s absolutely essential that you establish a formalized lending agreement between your S corporation and you. This agreement should include:
- The interest rate of the loan, which must absolutelynot be below the applicable federal rate
- When the loan will be repaid
- A consequence for failure to repay the loan
Essentially, the loan should be documented, just like a loan between your S corporation and an unrelated third party would be documented.
If your loan isnot documented just like any other loan would be, it could cause the IRS to determine that your “loan” is not a loan at all but rather disguised compensation.
Although collateral for the loan is not technically a requirement, a loan being collateralized is generally a helpful factor to indicate that a transfer of funds is, in fact, a loan rather than something else like a gift, a distribution, or shareholder compensation.
Repaying the Loan
Of course, it’s not enough to merely dot your i’s and cross your t’s with the loan agreement; you must also repay your loan according to schedule.
If you do not, the IRS could recharacterize the “loan.”
Think about it.
If this loan was to a third party, would your S corporation be so lenient as to let that third party borrower miss payments, even once in a while?
Of course not.
So the same should be true for your repayment of the loan from your S corporation — lenience on the part of your S corporation toward your failure to repay the loan in a timely manner would indicate to the IRS that this transfer of money was not a loan at all but something else.
Loan vs. Distribution
If the loan from your S corporation to you is not properly structured and documented, the IRS could reclassify the transfer of funds as a distribution.
You may be wondering what’s so bad about that since distributions out of an S corporation are generally tax-free since shareholders pay tax on their S corporation income based not on when they received cash out of their S corporation but on the S corporation’s taxable income during the year.
Althoughusually S corporation distributions do not have negative tax ramifications, they certainly could.
For example, if a shareholder does not have enough basis in the S corporation, any distributions they receive in excess of their basis would constitute taxable income.
Also, if only one shareholder out of several receives a “loan” from an S corporation and the IRS recharacterizes this “loan” as a distribution, this could cause that shareholder’s distributions for the year to exceed their S corporation ownership percentage.
This could have catastrophic tax consequences since this could indicate that the S corporation has two classes of stock, which would lead to an involuntary termination of the business’s S corporation election.
The Greenlee Case
Whatever you do, don’t be like Gale Greenlee.
In Gale W. Greenlee, Inc. v. United States, the taxpayer, Gale W. Greenlee, was the only shareholder-employee of Gale W. Greenlee, Inc.
The IRS recharacterized loans made to Greenlee from Greenlee’s S corporation as wages, and the United States District Court of Colorado agreed because:
- The loans were unsecured (i.e. they were not collateralized) and bore no interest.
- Greenlee merely took out the loans as he saw fit; there was no documentation of when these loans would be taken out.
- Greenlee performed services for the S corporation. Note that this is just one factor of money; obviously many S corporation shareholders perform services for their S corporation, and this fact alone does not indicate that a loan from the S corporation to them should be recharacterized.
- There were no actual repayments of the loan beyond accounting entries.
Although this case is merely a district court case, the IRS is certainly aware of this case and may use it in investigation purported loans made by S corporations to their shareholders.
S Corporation Loans to Shareholders: Conclusions
Here’s a summary of what you need to know about S corporations lending money to their shareholders.
- S corporations may loan money to their shareholders, but these arrangements should be taken with caution since the IRS could recharacterize these transactions as wages, distributions, or something else.
- It is essential for the loan between the S corporation and the shareholder to have all the markings of a loan that would be made to a third party such as a market interest rate, a repayment schedule, late payment fees, and consequences for failure to pay back the loan (such as the seizing of collateral).
- If the shareholder does not pay back the loan as stated in the loan agreement, it is important for the S corporation to treat the shareholder just as it would an unrelated third party. The S corporation’s failure to do this would be a major factor in favor of recharacterization.
- The IRS’s recharacterization of an S corporation “loan” to a shareholder as something else could have significant negative tax implications for the S corporation, the shareholder(s) “lent” money, and the other shareholders as well.
Book a Free Call: I’m a CPA with “Big 4” tax experience. If you’re interested in working with my firm on your S corporation tax matters, email me at [emailprotected].
