If you’re a principal or shareholder of an S-corporation, you already know the many tax advantages the structure provides you—and the few disadvantages you have to deal with.
Being part of an S-corp means your shareholder assets are protected and you can take advantage of pass-through taxation and other tax benefits, making the S-corp entity a good choice for both you and the business.
But what happens when the corporation needs an influx of money? The business may need to replace an expensive piece of equipment or grab a larger lease space that suddenly becomes available.
In situations like this, getting a bank business loan might take longer than you need it to, and a loan from a shareholder may seem like a better solution. But there are some important things shareholders should know about shareholder loans to ensure they don’t run into problems at tax time.
Capital Contributions vs. Shareholder Loans
If an S-corp needs short-term financing, there are two ways a shareholder might choose to help:
- A shareholder can make a capital contribution by purchasing additional shares of stock.
- A shareholder can make a loan to the S-corp.
Either type of contribution increases the shareholder’s basis in the S-corp. A capital contribution (also called paid-in capital) increases the shareholder’s stock basis; a loan increases the shareholder’s debt basis.
Basis is important because each shareholder can deduct pass-through losses up to the amount of their basis in the company. However, if their pass-through income exceeds their basis, that income is taxable to the shareholder.
Whether the money is classified as paid-in capital or a loan, and how that affects the shareholder’s stock and/or debt basis, can result in significantly different tax consequences for the shareholder. Depending on the chosen classification, setup and repayment must be handled differently—and judiciously.
Does a Shareholder Loan Make Sense?
Why would a shareholder choose to make a loan instead of a capital contribution? If the business is in the process of applying for financing that takes time to approve, as is the case with SBA loans, or just needs a short-term infusion of cash that a traditional loan like a bank business loan can’t offer, a shareholder loan can actually be a better alternative than paid-in capital for both the shareholder and the S-corp.
Here’s why: When there are multiple shareholders (and there usually are in an S-corp), the IRS requires any distributions from corporations to shareholders be “pro rata,” meaning the corporation can’t make special distributions to one shareholder and not the others.
Suppose the business needs to repay one shareholder $3,000. If there are 10 shareholders, the corporation would need to pay each of the shareholders that same amount, so it would need $30,000 before it could distribute repayment. Even if the corporation was going to make partial payments, it would still need to give all shareholders the same amount.
This is bad news for the shareholder who made the capital contribution and has to wait to get their money back.
If the money is in the form of a loan, however, the corporation only needs to pay the shareholder who made the loan. The shareholder can get their money back faster and the S-corp only has to pay out $3,000, not $30,000. It’s a win-win situation—provided there is a debt agreement in place.
Shareholder Loans: How to Craft a Debt Agreement
Because of the pass-through taxation they offer, S-corps are monitored closely by the IRS to make sure they’re not avoiding paying payroll taxes, and that the shareholder isn’t trying to avoid paying income taxes.
S-corp shareholders must pay taxes on any profits they make from selling stock or from dividends. Dividends are assets paid out from the corporation’s profits and considered taxable income for stockholders during the year in which they are distributed.
If a shareholder makes contributions to the S-corp as a loan, that shareholder enjoys the same protections of assets as a third-party lender would. In order for the contributions to be classified as a loan and enjoy favorable tax treatment, however, the IRS requires a bona fide debt agreement between the shareholder and the S-corp.
According to the IRS, in order to be considered “bona fide,” the agreement must have the following features:
- The agreement must be in writing. You can find templates online or ask your accountant/lawyer to supply one.
- There is a stated interest rate. Make sure that it’s a fair market interest rate or the IRS might come calling.
- There is a maturity date—the date when the loan must be repaid in full.
- The debt is enforceable under state law. Each state has its own statute of limitations for debt collection.
- You have a reasonable expectation that the debt will be repaid.
- You have remedies upon default (security interest or the position of the lender with respect to other creditors).
- Repayments are to be made per the terms of the agreement.
In addition, there should be some type of security or collateral for the loan. To avoid negative tax consequences for either the business or the shareholder making the loan, strict adherence to the loan agreement is essential.
Why a Debt Agreement Is Important for Shareholder Loans
It can be difficult to conceptualize how these business loans work, so let’s say a shareholder with a stock basis of $1,000 decides to make a capital contribution of $2,000 to fund a new project. In this example, the contribution simply increases the stockholder’s stock basis to $3,000. This stockholder can either:
- Have losses from the corporation passed through up to $3,000.
- Be paid back $3,000 without having to pay income taxes on that distribution.
If the losses in the same tax year exceed the shareholder’s stock basis, the stockholder may be able to carry the loss forward to offset future gains.
However, if the shareholder in our example above contributes the money in the form of a loan, things work a little differently. The shareholder now claims two tax bases: the $1,000 stock basis they started with, plus a $2,000 debt basis.
If losses reduce the stock basis to zero, future losses and deductions can be applied to the debt basis, reducing that. For example, if the stockholder with a $1,000 stock basis and $2,000 debt basis incurs losses of $3,000 in the same tax year, the shareholder’s stock basis and debt basis are both reduced to zero.
Shareholder Loans: No Debt Agreement vs. Debt Agreement
Still with us? Here’s where the tax issues get tricky and the shareholder may owe money to the IRS:
Let’s use the example above where the stockholder’s stock basis and debt basis are reduced to zero. Suppose that the following tax year, the S-corp pays $2,000 back to the shareholder.
- If the shareholder made a loan with no debt agreement in place, the $2,000 must be reported as income, which means the lender must pay income tax on the repayment.
- If the loan was made with a debt agreement in place, the $2,000 repayment can be considered capital gains, which is taxed at a lower rate than income tax.
Now, let’s say the corporation incurs a $2,000 loss instead of a $3,000 loss. What happens to the stock basis and debt basis? In this scenario, the shareholder’s stock basis is reduced to zero and the debt basis is reduced to $1,000. Therefore:
- When there is a loan, the debt basis must be restored (paid back) before the stock basis can be increased.
- Once the debt is repaid, then disbursements to the stockholder can be made to get the stock basis back to the original amount.
- Anything above the original amount of stock basis is considered income.
In general, loan repayment is not considered a sale or exchange of a capital asset, and therefore is considered ordinary income. But if the loan is supported by a bona fide debt agreement, the shareholder will only need to pay capital gains taxes instead of the higher income tax rate on the money they are repaid.
Shareholder Business Loans: The Final Word
It’s important to talk to a financial professional before entering into any financial agreement, even with a business of which you are a shareholder. In this situation, you may need to get creative to protect both your personal assets and the assets of the corporation. As in all business transactions, the more financial documentation you have in your corner, the better chance you have of a win-win situation.
Nellie Akalp is a passionate entrepreneur, small business expert and mother of four. She is the CEO of CorpNet.com, a trusted resource for Business Incorporation, LLC Filings, and Corporate Compliance Services in all 50 states. Nellie and her team recently launched a partner program for accountants, bookkeepers, CPAs, and other professionals to help them streamline the business incorporation and compliance process for their clients. More info at: CorpNet.com/partners.