1. Shareholder Loan Interest S Corp
2. Loans From Shareholder To Corporation

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)].

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

You have asked us to research how the Internal Revenue Service treats loans made to an officer/shareholder of a company in which the loan is not supported by a promissory note, and whether the IRS deems such a transfer to be compensation, rather than as a loan receivable. The IRS’s regulations, Taxpayer argued, recognize that back-to-back loans, if they represent bona fide indebtedness from the S corp to the shareholder – i.e., they run directly to the shareholder – can give rise to increased basis.

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.

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.

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.

TAX CASE

hen cash is transferred to a closely held corporation, is the transfer a loan or a capital contribution? The transfer is treated as a loan if there is an unconditional obligation to repay it. When there is a dispute, the courts look at factors such as the presence or absence of a written note, scheduled payments, a fixed interest rate, interest payments, collateral and a sinking fund. In addition, courts examine the corporation’s use of the transferred funds, its capital structure and its source of funds to make repayment.

Indmar Products Co. is a closely held corporation that manufactures marine engines. From 1987 to 2000 the shareholders made cash advances to the corporation in amounts ranging from $634,000 to $1.7 million that it reported as liabilities on its balance sheet. Indmar, in turn, made regular monthly interest payments to the shareholders based on an annual interest rate of 10% and also repaid various amounts to them. The shareholders reported the interest income from the advances on their individual tax returns while the corporation deducted the interest payments. The IRS denied the interest deductions on Indmar’s 1998 to 2000 tax returns and assessed a deficiency of $123,735. The taxpayer petitioned the Tax Court for relief.

The Tax Court ruled the advances were not loans because they were unsecured, were demand notes with no fixed maturity date, lacked an unconditional obligation of repayment and would not be repaid unless Indmar recorded a profit. Furthermore, Indmar had not paid any dividends or created a sinking fund from which to repay the advances. The taxpayer appealed the decision to the Sixth Circuit Court of Appeals.

Result. For the taxpayer. The Appellate Court applied the Roth Steel factors ( Roth Steel Tube Company v. Commissioner, 800 F2d 625) that it had developed in a prior debt/equity decision and, in a split decision, determined that the Tax Court had ignored some of those factors and misapplied others. Specifically, the Sixth Circuit ruled that the Tax Court had erroneously focused on the shareholders’ intent when they structured the advances as loans rather than giving proper weight to the fact that the advances had a fixed, reasonable interest rate that was used to make regular interest payments.

The court also disagreed with the Tax Court’s holding that the absence of written instruments between 1987 and 1992 indicated there was no unconditional and legal obligation to repay the advances, noting the existence of written notes for all years after 1992, which the Tax Court ignored. In addition, the Sixth Circuit disagreed that the demand notes represented equity because of the lack of a fixed maturity date. It said that a loan requires an ascertainable maturity date—which a demand note has—not a fixed maturity date, and the Tax Court’s interpretation would disqualify shareholders from using a common type of commercial loan. The court also said the Tax Court had ignored the credible testimony of one of the company’s shareholders that he fully expected to be repaid the amounts he had advanced to Indmar.

Shareholder Loan Interest S Corp

Finally, the Sixth Circuit gave little weight to Indmar’s lack of a sinking fund and collateral since the company was not highly leveraged. The absence of dividend payments during the years in question also was not considered significant because the shareholders had been advancing money to Indmar at that time in addition to receiving interest payments. Also, the amount of interest paid on the advances was based on a reasonable rate; an unreasonably high rate of interest would have indicated a disguised dividend.

This case emphasizes that shareholder advances to a closely held corporation will be treated as loans if the characteristics of the agreement are similar to those for loans made to the corporation by an unrelated party. (For background information on the lack of guidance regarding debt vs. equity, see From the Tax Adviser , page 76.)

Indmar Products Co. v. Commissioner, 444 F3d 771.

Loans From Shareholder To Corporation

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.