As the owner of a medium-sized corporation, I’ve considered taking loans from my business, versus a traditional financial institution. What do I need to be aware of from a tax standpoint, to do so responsibly?
This isn’t an unusual occurrence in our experience. Owners occasionally need to borrow funds from their businesses, and, if your business is structured as a corporation and it has extra cash on hand, it can be a convenient and low-cost option. But we always urge our clients to treat the transaction as a bona fide loan, with all of the accompanying benefits and drawbacks. If you don’t, the IRS can claim that you received a dividend or compensation payment rather than a loan, which will add to your tax burden.
What are the rules?
A corporation can make de minimis loans of $10,000 or less to shareholders without paying interest. But, if all the loans from the corporation to a shareholder add up to more than $10,000, they may be subject to a complicated set of below-market interest rules unless you charge what the IRS considers an “adequate” rate of interest. Each month the IRS publishes its applicable federal rates (AFRs), which vary depending on the term of the loan.
The current interest rate environment can make borrowing very attractive. Interest rates are starting to rise, but they are still near historic lows. For example, in July 2017, the adjusted AFR for short-term loans (of not more than three years) was only 1.22%. The rate was 1.89% for midterm loans (with terms ranging from more than three years to not more than nine years).
These aren’t usually the same rates you’ll see if utilizing a bank for your loan. The AFRs are typically below what a traditional financial institution would charge. As long as the corporation charged interest at the AFR (or higher), the loan would be exempt from the complicated below-market interest rules the IRS imposes.
The interest rate for a demand loan — which is payable whenever the corporation wants to collect it — isn’t fixed when the loan is set up. Instead it varies depending on market conditions. So, calculating the correct AFR for a demand loan is more complicated than it is for a term loan. In general, it’s easier to administer a shareholder loan with a prescribed term than a demand note.
If a corporation lends money to a shareholder at an interest rate that’s below the AFR, the IRS requires it to impute interest using the below-market interest rules. These calculations can be complicated. The amount of incremental imputed interest (beyond what the corporation already charges the shareholder) depends on when the loan was set up and whether it’s a demand or term loan. There are also tax consequences for this imputed interest to both the corporation and the shareholder.
Additionally, the IRS may argue that the loan should be reclassified as either a dividend or additional compensation. The corporation may deduct the latter, but it will also be subject to payroll taxes. Both dividends and additional compensation would be taxable income to the shareholder personally, however.
Treat it like a traditional loan
When executing shareholder loans, it’s important to treat the loan itself and the process as if it were coming from a traditional source. When deciding whether payments made to shareholders qualify as loans, the IRS considers a variety of factors, including the size of the loan, as well as the organization’s earning history, prior dividend payments and loan repayments. It also will evaluate the shareholder’s ability to repay the loan and power in the corporate decision-making process.
The IRS will also factor in whether you’ve executed a formal, written note that specifies repayment terms — including the interest rate, maturity date and collateral, so be sure to cross all the t’s and dot all the i’s.
Even with these considerations, a shareholder loan can be a smart tax planning move. If you are considering one, just be sure to talk it through with a CPA and your legal advisor to ensure you execute the loan in compliance with the latest IRS rules and terms.
Tom Cooney and Crystal Faulkner are partners with MCM CPAs & Advisors, a CPA and advisory firm offering expert guidance and beyond the bottom line thinking for today’s public and private businesses large and small, not-for-profits, governmental entities and individuals. For additional information, call 513-768-6796 or visit us online at www.mcmcpa.com.