Business loans in an S Corporation are a complicated topic. In this article, we will consider two of the most common situations: the infusion of cash from the shareholder to the S Corp and loans from third parties.
Understanding the Difference Between a Loan from the Shareholder and a Contribution from the Shareholder.
The shareholder contribution to the S Corp and the shareholder loan to the S Corp can be easily reclassified on the balance sheet. Many tax practitioners do this type of reclassification for various reasons. Although these types of re-classifications are common, they are technically incorrect, and the IRS does not look favorably upon them. The IRS requires proper documentation for the loans to the company—such as a promissory note, repayment terms, and interest payments for all types of loans. Without these elements, the IRS might reclassify the shareholder loan as a second type of stock, which could potentially jeopardize your S Corp qualification since S Corps can have only one type of stock. However, IRS audit rates for S Corps are relatively low, which is why we may not often hear about this problem.
When Are S-Corp Loans from Shareholders More Beneficial than Contributions?
A shareholder loan to the S Corp can be more beneficial than a contribution when in a multi-member S Corporation, one of the shareholders might later want to withdraw funds without violating the tax rule requiring proportional distributions to all shareholders. By classifying an infusion as a loan instead of a contribution, the shareholder gains the flexibility to take money before other members and without triggering disproportionate distributions (one of the requirements to maintain S Corp status). However, as we noted before, to classify the cash infusion as a loan, there should be proper documentation between the S Corp and the owner, and a history of payments.
Understanding the Difference Between a Loan from the Shareholder and a Loan from a Third Party (Lender).
In an S Corporation, there are two types of basis: stock basis and loan basis. Shareholder contributions and distributions affect stock basis, while loans made by the shareholder to the S Corporation affect loan basis. Both bases are important because they determine whether you can deduct S Corp losses on your personal tax return. Without sufficient basis, you can’t deduct your losses, and they will be carried over to future years. Additionally, without sufficient basis, your distributions from the S Corporation are treated as capital gains.
Here’s where things get tricky. Generally, the IRS views business loans as loans to the corporation itself, even if personally guaranteed by a shareholder. Business loans from a third-party lender don’t increase shareholder loan basis and aren’t classified as shareholder loans on the balance sheet. Only loans from the shareholders can increase their basis.
Why does this matter? Let's see. Suppose you take out a bank loan for your S Corporation’s activities, and the bank deposits the money directly into the S Corporation’s account. This loan is classified as a business loan, not a shareholder loan, so it doesn’t increase your debt basis. If you then withdraw the money from the S Corporation and your basis is zero, you’ll pay capital gains tax on the amount withdrawn. For example, if your S Corporation borrows $100,000, your basis is zero and you withdraw cash to buy a car, you’ll recognize capital gain on the difference between your withdrawal and your basis, which is $100,000. This is a very good article covering most of the court cases on this topic.
So, What Exactly Classifies as a Business Loan?
A loan is considered a business loan and not a shareholder loan for an S Corporation when it meets two key criteria:
- Direct Loan to the S Corporation: The loan must be made directly from the shareholder to the S Corporation. The money must go straight to the S Corporation without any intermediaries.
- Bona Fide Debt: The loan must be a bona fide debt, meaning it must be a valid, enforceable obligation with a real expectation of repayment. The terms should resemble those of a typical loan between unrelated parties, with documentation, a fixed repayment schedule, and a fair interest rate.
If these conditions are met, the loan qualifies as business debt, which doesn’t increase the basis for loss deductions and prompts capital gains on excessive distributions. However, if the loan was classified as a shareholder loan, the transaction could be tax-free because the loan would increase your basis, which in turn would prevent capital gains.
Preventing Tax Issues with business loans:
To avoid these problems, consider these strategies:
- Return the Money to the S Corporation: If you’ve taken money out, returning it to the S Corporation as soon as possible can help mitigate potential tax issues.
- Classify Loans Correctly from the Start: Ideally, classify the loan as a shareholder loan from the beginning. You can do this by asking the lender to disburse the loan directly to you, not the S Corporation. After receiving the funds, create a formal loan agreement with the S Corporation, specify the interest rate, and then transfer the money to the corporation. Start paying the interest on the money borrowed. This ensures that the shareholder loan basis increases, making future distributions non-taxable.