Irs Loans From Shareholders

If you own your private corporation and borrow money you should consider the income tax consequences.

The Income Tax Act contains a series of rules that may have income tax consequences for the person receiving the loan from the company. In the context of this article, the term loan means any form of debt the shareholder or family member has to the corporation. The term shareholder should be taken to mean the shareholder of the corporation or members of the shareholders family.

These rules exist to prevent shareholders of private companies from taking out a series of back-to-back loans and avoid personal income tax altogether.

• Consequently, it’s prudent for them to know, in advance of deciding to take an ownership stake in their companies, how the Internal Revenue Service and the courts look at worthless loans. Let’s say a shareholder-employee made the loan or guaranty as an employee in order to protect her job. In that case, the loss qualifies as a business bad.
• Shareholder loans can be a useful way to manage short-term personal cash needs. They also allow shareholders more flexibility in how and when cash is withdrawn from a company. If you are just needing a short-term loan for less than a year, a shareholder loan could be an easy way to obtain the funds.
• The following probably sounds familiar. You’re meeting with a new client who is being audited by the IRS. The client brings you their federal and state individual income tax returns and the income tax returns for their business entity. You look at the client’s reported wages and dividends; you look at.

General Tax Rule For Shareholder Loans

The general rule is that your shareholder loan must be repaid within one year from the end of the corporations’ tax year then the loan will not be taxed in your hands.

You may be able to have the loan outstanding for longer that 12 months depending on when the loan was taken out and the corporation’s year end. However, caution must be taken as missing the repayment deadline can have some unwelcome tax consequences.

3 Exceptions To The Shareholder Loan Rules

There are three general exceptions to shareholder loan provisions under the income Tax Act.

Loans to S Corporation Shareholder Often times a payment or payments to S corporation shareholders will be booked or accounted for as a loan to shareholder. Sometimes this is purposefully, other times, it may be due to lack of options.

1. One Year Rule – As outlined above,if the loan is repaid by the shareholder within the year after the end of the corporations’ tax year, the loan is not included in income.

However, the loan cannot be a series of loans and repayments. On the other hand, if a current loan account is maintained in the corporation for a shareholder during a tax year and the year-end balance is repaid from salary or declared dividends the CRA will generally not consider these transactions as a series of loans or repayments.

2. The Lenders Rule – If the corporations’ business is lending money or the debt is from the normal business activities then the loan is not considered a shareholder loan, provided standard arrangements are made for repayment and are maintained.

3. Principal Residence Rule – If the shareholder is also an employee and a loan is advanced to purchase a principal residence, new shares in the corporation, or a vehicle to be used for business purposes then the loan is not considered income (more details at lendgenius.com). In addition, the loan must be advanced due to employment and not due to shares held and standard arrangements are made for repayment are made and maintained.

Repaying A Shareholder Loan

Irs Loans From Shareholders Loan

When the loan is repaid that was previously included in income for tax purposes, it may be deducted from income of the year of payment.

Before you take a loan, be sure to discuss the matter with your accountant. If the loan is not properly structured, the costs of the loan could be substantial.

Help With shareholder Loans

With more than 15 years of professional accounting tax experience we can help you structure the most efficient compensation systems to hep you maximize your income and PAY LESS TAX!

Call us today at (289) 288-1206 or send us an email to find out how Dean Paley Certified General Accountant can help you get the most out of your business.

The information in this article is for general use only and should not be considered advice or a recommendation.

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Shareholders often loan money to their corporation in order to keep the business operating. There are rules and regulations in the Internal Revenue Code (IRC) that must be adhered to in order for loans to be treated as such, and not an equity contribution.

When a shareholder makes a loan to a corporation, the loan is classified as a Demand Loan or Term Loan. A Demand loan is defined in IRC Section 7872(f)(5) as:

1. A loan that is payable in full any time at the demand of the lender, or
2. To the extent defined by the regulations, a loan with an indefinite maturity.

A Term Loan is defined in IRC Section 7872(f)(6) as any loan that is not a demand loan.

Now, let’s discuss the various tax differences of using debt vs equity:

1. Debt repayment by the corporation is not an earnings distribution to the shareholder, and therefore it is tax-free
2. Dividend distributions are not deductible by the corporation, whereas interest payments are deductible under IRC Section 163
3. Dividend distributions are taxable to the shareholder to the extent of the corporation’s current or accumulated earnings and profits (IRC Section 301(c)(1). Distibutions 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 (IRC Section 301 (c)(2). Distributions in excess of the shareholder’s basis are taxed a a capital gain ( IRC Section 301(c)(3)], if the stock is held as a capital asset, and if the corporation is not a collapsible corporation (IRC 341)]. Interest payments are always fully taxable to the recipient shareholder [IRC Section 61 (a)(4)].
4. The presence of debt may allow the corporation to accumulate earnings without subjecting itself to an accumulated earning tax ( IRC Section 531)
5. If the issuing corporation’s debt becomes worthless, the debt holder’s loss may capital or ordinary depending on whether the debt is a business or nonbusiness bad debt ( IRC Section 166). If the corporation’s stock becomes worthless, a shareholder is generally entitled to a capital loss IRC Section 165(g)(3)]. In some small business corporations, an ordinary loss may be available (IRC Section 1244)].

Irs Loans From Shareholders

If the IRS re-characterizes a purported loan from a shareholder to be a capital contribution, the following occurs:

1. The Corporation loses its interest deduction-reclassified as a dividend distribution
2. Principal payments thought to be tax-free to a shareholder become taxable dividend income, provided sufficient earnings and profits exist
3. 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 the basis is exceeded.

Irs Loans From Shareholders Pay

The debt vs 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 following factors attribute to the classification:

1. Is there a formal promissory note?
2. Is there a fixed obligation to pay interest?
3. Are there regular and timely payments of interest?
4. Is the debt/equity ratio more than 4 to 1–thin capitalization
5. Is debt payment contingent on profits

The IRS uses a Market Segment Specialization Guide when conducting audits. One should be familiar with this document, if engaged in the practice of lending funds to their C Corporation.

Loan To Shareholder

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 schedule. We all know the answer to the rhetorical question. To avoid reclassification of loan repayments to dividend income, be cognizant of the rules and regulations cited in this brief article.