Shareholder loans, as the name implies, are funds that shareholders lend to the corporation in which they hold shares. To qualify as a shareholder loan under Internal Revenue Service code, the loan cannot be to start a corporation; it must be an established business. IRS regulations do allow loans from a shareholder who holds all of a corporation's shares.
The Internal Revenue Service recommends that shareholder loan contracts include specifics that would be found in a loan between unrelated parties. Contracts should specify the loan amount, interest rate applied, repayment term, and the consequence for not repaying appropriately. If borrowers are providing collateral to secure the loan, the contract should state the collateral offered and the disposition in case of nonpayment.
Below Market Loans
Shareholder loans charging no interest or an interest rate below the federal rate are known as below-market loans. The Internal Revenue Service publishes the federal rate monthly in the Internal Revenue Bulletin, available on the IRS website. Loans with advantageous interest rates have varied tax consequences for borrowers, depending on the details of the arrangement.
Tax Implication of Loans
The amount of interest not charged by below-market loans is considered income and is taxable to the borrower. Taxpayers determine this taxable amount by subtracting the amount of interest actually paid from the amount of interest that would be due if the shareholder loan was charged at the federal rate. Borrowers should compute this amount annually and report when filing their taxes.
The foregone interest may not be taxable on a below-market loan with a balance due of $10,000 or less. Corporations must have entered into the low-interest or interest-free loan with a principal purpose other than tax avoidance to qualify for this exception. Shareholder loans originating with a larger balance qualify for this exemption once the balance falls to $10,000 or less.