August, 2005 Tax Tip
Be Careful With Shareholder Loans
Many of my corporate clients make periodic loans or advances to their shareholders and/or employees (“shareholder-employee”). In other situations the corporation will pay personal expenses of the shareholder, such as home or car expenses. I find that, until they work with me, they haven’t had a true understanding or appreciation that the corporation is a legal entity separate from the shareholder and must be treated as such for tax purposes. Therefore, any time the corporation makes a payment of any kind to, or for the benefit of, a shareholder-employee the transaction must be treated properly by both parties.
A typical scenario is where the shareholder-employee takes an advance, rather than a salary, from the corporation because he does not want to deal with the payroll tax issues that would arise if it were a salary. No problem – UNTIL the IRS enters the picture by seeing the loans on the corporation’s tax return balance sheet and decides to audit the company. The agent will look at the facts and circumstances surrounding the advances to determine whether they were in fact bona fide loans. In other words, the loans should be structured and documented as though they were obtained from a bank.
The auditor will request documentation to prove that the loans were valid. A key item is whether there was a reasonable expectation that the loan would be repaid at the time it was made. Other factors considered are the individual’s ownership of the company, whether any security was involved, the ability of the individual to repay the loan, whether the corporation had adequate earnings to make the loan, documentation of the loan agreement (including repayment schedule), the interest rate charged, and the dividend payment history of the corporation. The more of these factors that are present, the better the chance will be that the transactions will avoid being reclassified.
If the advances are reclassified from loans to shareholder distributions, the tax effect to the shareholder depends on whether the corporation is a “C” corporation or an “S” corporation. An “S” corporation is one in which the shareholders have elected to include the corporation’s income on their personal tax return. A reclassified loan to an “S” Corporation shareholder is treated as a distribution which, if greater than his basis in the corporation, would be taxed at capital gain rates, currently at a maximum 15%.
However, if the corporation is a “C” corporation, the distribution is a dividend taxed at ordinary income tax rates (prior to the 2003 tax law – see below) to the extent of the corporation’s earnings and profits; any excess would be considered a return of the shareholder’s investment and the balance is taxed as a capital gain.
Tax Planning Tip – What if the shareholder chooses not to repay the loan? The 2003 tax law (see discussion on my web site) reduced the tax rate on dividends from a domestic corporation to a maximum rate of 15%. Therefore, if the corporation is a “C” corporation and the loan is reclassified as a dividend, the shareholder would pay no more than 15%. If the corporation is an “S” corporation, the advance would be reclassified as a distribution which, if greater than the shareholder’s basis, the excess would be taxed as a capital gain with a maximum 15% rate.
Therefore, borrowing funds from one’s corporation might not be all that bad. It clearly behooves the parties to do the right things to have the transaction regarded as an arms length, bona fide loan. However, If the loan is not repaid, there is a likelihood that the tax would be no more than 15%.
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