Owners of privately held businesses sometimes make loans to or borrow money from their companies. An owner makes a loan to the business when it is temporarily short of cash to eliminate the necessity of going to the bank and seeking approval for a loan or facing a denial.
TL;DR (Too Long; Didn't Read)
A shareholder loan is debt-like financing provided from a shareholder to the company, or from the company to the shareholder.
What Is a Shareholder Loan?
Shareholder loans have two sides:
- Loans from the shareholder to the company
- Loans from the business to the shareholder
When the owner makes a loan to the business to cover temporary cash shortages, the transaction is booked in a Due to Shareholder account. In this case, the owner takes funds from a personal account and deposits them into a company business account.
Funds that flow from the company to the owner create an advance or loan that is booked as Due From Shareholder. This is the transaction that may create problems with the IRS.
Shareholder Loans to the Business
A shareholder loan is a form of financing for the company and represents debt. These types of loans should receive the same treatment as a loan between two independent parties. Loan repayment is not taxable, and the company gets a deduction for the payment of interest.
If the company treats shareholder advances as contributions to equity, any repayment or reimbursement from the company could be taxed as distributions.
An advance that is treated as a loan vs. an equity investment for the owner is particularly advantageous in the case of a bankruptcy. Since debt obligations have priority in bankruptcies, the debt is repaid, including owner loans, before the shareholders receive any return of their equity.
What if the Owner Withdraws Funds?
Is it a loan? Or is it an owner's draw or salary? Owners sometimes take cash out of their businesses to pay for personal expenses, such as buying a car for their spouse, for example. The bookkeeper enters the withdrawal in the accounting records as a loan Due From Shareholder. The problem is how the IRS views these transactions.
The IRS attempts to determine if the withdrawals, which are classified by the company as loans, are instead compensation or dividends. In these cases, the payments to shareholders could be reclassified as salaries and have tax consequences.
If the payments come from a C corporation, they could be classified as dividends and taxable to the owner on the personal return as ordinary income, resulting in double taxation.
In the case of an S corporation, withdrawals may be considered a distribution. Because S corporations are pass-through entities, distributions reduce an owner's tax basis, making it harder to deduct business losses. If the IRS sees the withdrawal as compensation, similar to a C corporation, the withdrawal is taxable and subject to payroll taxes.
How to Keep Shareholder Loans Strictly Business
When a shareholder borrows money from the company or vice versa, an agreement should outline how and when the funds will be paid back. The agreement should be in writing to make it legally binding. The law is clear: Companies must document and write down all such transactions. Without written documentation, disputes could erupt that lead to legal and emotional difficulties, and everything winds up in court.
To make loan transactions legitimate, treat them like any other arms-length negotiation with the following conditions:
- Have an executed promissory note
- Charge a reasonable rate of interest
- Follow a fixed repayment schedule
- Secure it with the appropriate collateral
- Treat it as a loan in the company's books
One way to avoid the appearance that loans to owners are not compensation in disguise is to make sure that they receive reasonable salaries on a regular basis common to their industry.
Shareholder loans are common transactions in closely held businesses. However, when properly set up, they comply with standard loan agreements and avoid potential problems with the IRS.
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