Can I Take a Loan Out of My S-Corp?

Can I Take a Loan Out of My S-Corp?

Of course you can!

But is it always the best choice? Hmmm, it all depends on your situation.

And if not, what are the alternatives?

In our tax practice, we’ve seen a lot of shareholder loans go bad. So, let’s break down the disadvantages of shareholder loans, when they might actually make sense, and what other options you might have. And hey, if after reading this blog you’re still convinced a shareholder loan is what you need, go for it! (but, you know, make sure you’ve read the fine print).

The Disadvantages of Taking a Loan from Your S-Corp

1. Additional Paperwork and Payment Schedule: Just like any loan, a shareholder loan from your S-Corp requires a clear, written promissory note (fancy, right?). You’ll need to set terms for repayment, including how often you’ll make payments (monthly, quarterly, etc.), the interest rate (and no, not the ridiculously low one), and the duration of the loan. The loan needs to resemble a typical loan agreement — like the ones with a bank. Unlike a shareholder distribution, which doesn’t need to be repaid, a loan from your S-Corp must be repaid according to the agreed-upon paperwork.
2. IRS Scrutiny. Failing to follow the loan rules could result in the IRS reclassifying the loan as a distribution, wages, or even a second class of stock. This could lead to penalties, back taxes, and possibly losing your S-Corp status, which would then convert your S-Corp into a C-Corp — with much higher taxes. Ouch!
3. Tax Consequences of Loan Repayments. Loans are expected to be repaid. If the S-Corp decides to forgive the loan to its owner, the IRS will consider the forgiven debt as income — and you’ll be taxed on it at your individual tax rate. But wait, there’s more! The repayment of a shareholder loan itself is also a taxable event. If your debt basis was reduced (we explained debt basis — it's a bit tricky) and you now repay the loan, the repayment will generate taxable income. For loans under $25,000 that aren’t documented, repayment will be classified as ordinary income. Loans above $25,000 that are documented may qualify for capital gains treatment instead. So yeah, loans sound fun, but they can get pretty expensive pretty fast.

Why don’t we hear much about the negative consequences of shareholder loans? Well, IRS audits of S-Corps have been relatively rare, and when they do happen, they mostly focus on reasonable compensation issues. Also, in many cases, tax accountants may reclassify items in a client's books without explaining the situation to their clients. Shareholder loans don't directly affect profit, loss, or taxes, and in our experience many business owners are not overly concerned about non profit items on their books. However, as IRS audits are expected to increase, it's important to understand how a shareholder loan can play out.

But now let's talk about more positive things.

When Is a Loan from Your S-Corp Actually Useful?

There are situations where taking a loan from your S-Corp might make sense:

1. Insufficient S-Corp Basis In some cases, you may find that your S-Corp’s basis is less than the balance of the cash in your S-Corp's bank account. You can read about the concept of S-Corp stock basis here. Generally, insufficient basis occurs due to unearned income or a third-party loan that gets deposited into your S-Corp's bank account. It can also happen due to a big depreciation expense as well. When you take a distribution from the S-Corp with a low basis, the distribution is taxed at the capital gains tax rate. You can proactively prevent this taxable event by borrowing money from your S-Corp instead of simply taking a distribution. Here is a quick example: An S-Corp receives a loan from a bank, and the shareholder then takes this money out and uses it for personal purposes. Because of insufficient S Corp basis, such a distribution would create a taxable event. However, because the withdrawal was properly structured as a shareholder loan, the taxable event did not occur.

   Tax Pro Tip: If you want to check your S Corp basis, look for either Form 7203 or the basis tracking workpaper on your personal 1040 tax return. If you can't find this information, you may need to contact your tax accountant or if you don't have one, you may need to recreate the basis number by looking at your previous S Corp tax returns.

2. Disproportionate Distributions Among Multiple Shareholders The tax law requires that S-Corp distributions are must be proportional to ownership percentages. For S-Corps with multiple owners, disproportionate distributions will invalidate the S-Corp election, converting it into a C-Corp. In cases like this, a shareholder loan is the way to withdraw a large amount of money from the S-Corp without violating S-Corp rules.

But, what if your S-Corp has plenty of basis and no other shareholders? Do you still need a shareholder loan? Well, probably not. A shareholder loan in this case may be overkill — like wearing a tuxedo to a backyard barbecue.

Alternatives to Taking a Shareholder Loan:

1. Paying Yourself Wages You can always pay yourself a salary, and the IRS will be fine with it. However, this option requires you to pay self-employment taxes. If you’ve already hit the self-employment tax cap, you’ll still be required to pay the 2.9% Medicare tax, which does not have thresholds. Besides that, S corp share of self employment taxes is not refundable also, so you will simply lose that amount. This makes wages the least attractive option of withdrawing money out of the S Corp.
2. Taking Distributions If you have sufficient basis in the S-Corp, you can take distributions directly from the company. This is the easiest and simplest accounting procedure. And the IRS approves it! Distributions don't require the repayment terms of a loan agreement, nor do they require any additional paperwork. All you need to do is transfer money to your personal account and mark it as a shareholder distribution in your books, and you are good to go!

What to Consider When taking a Distribution:

1. Sufficient Shareholder Basis Again, you will need to check if you have sufficient basis in your S corp to take distribution. You can check your basis on Form 7203. If you see that your basis is low, you may want to go the shareholder loan route.
2. Reasonable Compensation The IRS is picky about this. The IRS states that in a profitable year, you need to pay yourself a salary (and pay self-employment taxes on it) before you take a distribution. So, if you withdraw money from the company, please make sure you pay yourself as well. The IRS has the ability to cross-reference shareholder distributions with their wages on the S Corp tax return, and no one wants to be flagged for an audit.

Final Thoughts

While you can take a loan from your S-Corp, it’s not always the best choice. It requires careful documentation, following IRS guidelines, and sticking to a strict repayment schedule. Shareholder loans can be useful in certain situations, like when your basis is low or when you need disproportionate distributions. But, often, a distribution is simpler and avoids the tax complications of a loan.

Before pulling the trigger on a loan, it’s a good idea to chat with a tax professional. We’ve helped hundreds of business owners with their taxes, and if you’re ready to talk, you can check out our services here!