It’s common for closely-held businesses to transfer money into and out of the company, often intended to be in the form of a loan. However, the IRS tends to look closely at such transactions and would like to reclassify them. Depending upon certain factors (and what the IRS would like to achieve), these dollar amounts may be classified as:
- Loans,
- Compensation,
- Distributions, or
- Contributions to equity.
Since compensation, distributions, and equity infusions are usually planned-for events, let’s look at how it may be helpful to utilize loans to and from your business.
Loans to owners
When an owner withdraws funds from the company, the amount could be characterized as compensation, a distribution, or a loan. Loans aren’t taxable, but compensation is; and distributions may be.
If the company is a C corporation and the transaction is considered a distribution, it can trigger double taxation. If a transaction is considered compensation, it’s deductible by the corporation, so it doesn’t result in double taxation — but it will be taxable to the owner and subject to payroll taxes.
If the company is an S corporation or other pass-through entity and the transaction is considered a distribution, there’s no entity-level tax, so double taxation won’t be an issue. But distributions reduce an owner’s tax basis, which makes it harder to deduct business losses. If the transaction is considered compensation, as with a C corporation, it will be taxable to the owner and subject to payroll taxes.
Most, if not all, of these problems can be prevented with adequate planning. We can help you establish your desired intention with a shareholder loan agreement or other required documentation. There are actually occasions where, from a tax standpoint, a dividend may be taxed at a lesser rate than a bonus.
Loans to the business
There are also benefits to treating transfers of money from owners to the business as loans. If such advances are treated as contributions to equity, for example, any reimbursements by the company may be taxed as distributions. Whether this is helpful or not is often determined by the tax status (C or S) of your corporation.
Loan payments, on the other hand, aren’t taxable, apart from the interest, which is deductible by the company. A loan may also give the owner an advantage in the event of a financial disaster because debt obligations are paid before equity is returned. This is one area where IRS would like to change your transaction to something that they like a little more.
The question they’ll ask is:
Is it a loan or not?
To enjoy the tax advantages of a loan, it’s important to establish that a transaction is truly a loan. Simply calling a withdrawal or advance a “loan” doesn’t make it so.
Whether a transaction is a loan is a matter of intent. It’s a loan if the borrower has an unconditional intent to repay the amount received and the lender has an unconditional intent to obtain repayment. Because the IRS and the courts aren’t mind readers, it’s critical to document loans and treat them like other arm’s-length transactions. This includes:
- Executing a promissory note,
- Charging a commercially reasonable rate of interest — generally, no less than the applicable federal rate,
- Establishing and following a fixed repayment schedule,
- Securing the loan using appropriate collateral, which will also give the lender bankruptcy priority over unsecured creditors,
- Treating the transaction as a loan in the company’s books, and
- Ensuring that the lender makes reasonable efforts to collect in case of default.
Also, to avoid a claim that loans to owner-employees are disguised compensation, you must ensure they receive reasonable salaries.
If you’re considering a loan to or from your business, contact us for more details on how to help ensure it will be considered a loan by the IRS.
David Conley
He is also a founding Board Member and Finance Director of the Fayette Pregnancy Resource Center and serves on the Board of the National Equal Rights Institute.
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