Article: Making Loans Between Yourself and Your Corporation


	Lynn Westergard

December 2004

Making loans between yourself and your corporation

Poorly documented loan transactions will almost certainly open up a can of worms

The financial lives of shareholders and their closely held corporations are often tightly intertwined. As a result, it’s not unusual for shareholders to make loans to their corporations and vice versa. Avoiding tax and other problems associated with such loans requires up-front planning.

Lending to your corporation

If your investment in a successful C corporation is entirely characterized as equity (i.e., stock), it will be difficult to withdraw any of your stake without some or all of the withdrawal being treated as a dividend. (This is normally not a problem with S corporations, because funds can generally be taken out tax-free to the extent of the withdrawing shareholder’s stock basis.) As you may have already learned the hard way, dividends from a C corporation are generally bad news because they are taxable to you, but your corporation cannot deduct the payments. The harshness of double taxation was softened somewhat when Congress lowered the maximum dividend tax rate to 15%. Nevertheless, a dividend paid to you by your corporation is palatable from a tax standpoint only when your personal income tax rate exceeds 30% and your corporation’s tax rate does not exceed 15%.

In contrast, when part of your investment is in the form of a shareholder loan to your C corporation, you gain the following tax advantages:

You can collect the loan principal repayments tax-free. Thus, you can recover part of your investment in the corporation without triggering any taxes.
The interest payments to you are deductible by your corporation. This allows you to withdraw additional cash corporation without double taxation. Furthermore, although you will pay income tax on this income, it isn’t subject to payroll taxes.
The requirement to make debt payments can reduce your corporation’s exposure to accumulated earnings tax.

Guidelines. To lock in the tax breaks, you want to ensure that the IRS will treat your arrangement as a loan rather than as disguised equity. Here are the guidelines to follow.

You should receive a written promissory note from the corporation stating that the company is making an unconditional promise to repay on demand a specified sum at a fixed maturity date or in installments on specified dates. Preferably, the interest rate should be at least equal to the applicable federal rate or AFR (more on that later).
Your corporation should not be “thinly capitalized.” If it is, the IRS may try to recharacterize purported corporate debt as disguised equity, which would put you back into the double-taxed dividend scenario. Thin capitalization is a potential problem whenever the corporation’s ratio of debt to equity is considered excessive for the industry. It’s difficult to generalize about when a corporation will cross the thin capitalization line. However, you should address the issue whenever any new debt will cause the debt-to-equity ratio to exceed about 3:1.
At the time the loan is made, the corporation’s financial condition should indicate it is capable of repaying the loan according to the terms of the promissory note, and adequate collateral should exist.
The corporate minutes should reflect that taking on the debt was authorized by corporate officers and should include a summary of the loan terms (interest rate, repayment schedule, collateral, etc.).
Your corporation’s financial statements and your personal financial records should reflect a loan between you and the corporation. The same goes for any financial statements given to lenders or issued to third parties for regulatory or credit rating purposes.
Avoid convertible debt instruments; debt that can be converted into stock has historically been looked upon less favorably by the IRS than debt with no conversion feature.
Perhaps most important of all, the interest and principal payments should be made on time. If the corporation misses scheduled payments, the promissory note should be amended to reschedule them. When payment deadlines go by with “no comment” from the lender and no collection activity against the borrower, the IRS can make a much stronger case that the purported debt was actually disguised equity.

Borrowing from your corporation

It’s quite common for a closely held C corporation to advance funds to a shareholder with little or no thought about the tax consequences. Although the transaction may be intended as a loan, documentation is often lacking. Once again, this opens the door for the IRS to claim that the payment to the shareholder was actually a disguised dividend rather than a loan. If the IRS is successful, double taxation will result. To avoid that, follow the earlier guidelines about loans from you to your corporation. The advice is equally relevant for loans going the other way.

Even if the transaction is clearly a loan, there can still be unfavorable tax consequences under the below-market interest rules when too little (or no) interest is charged. However, you need not worry about the below-market interest rules if the aggregate outstanding balance of loans from the corporation to you is $10,000 or less. If you qualify for this loophole, your corporation can charge very low interest or zero interest with no harm done.

You also need not worry about the below-market interest rules if your corporation charges an interest rate at least equal to the applicable federal rate (AFR), which is the minimum that can be charged without creating unwanted tax side-effects. (The IRS publishes AFRs monthly in the Internal Revenue Bulletin and at www.irs.org.) The relevant AFR for a particular loan is the one in effect for loans of that duration for the month the loan is made. For example, for loans made in October 2004, the AFR would have been:

2.24% for a term of up to three years;
3.56% for a term of three to nine years; and
4.73% for loans of nine years or longer.

Once the AFR is determined, it continues to apply over the life of the loan, regardless of how interest rates may fluctuate during that time. An exception applies to demand loans, for which the AFR is re-determined annually by “blending” the monthly short-term AFRs for that year.

As you can see, the AFRs are much lower than the rates charged by commercial lenders. However, as long as your corporation charges you at least the AFR, you won’t have to worry about any of the tax complications explained below. Your company will have taxable interest income equal to the stated interest rate, and you will have an equal amount of interest expense (which may or may not be deductible, depending on how the loan proceeds are used).

Imputed payments. When the below-market interest rules do apply – for example, because your corporation loans you over $10,000 at zero interest – the tax laws say you must calculate “imputed” or imaginary payments between you and the company. The imputed payments are calculated using the difference between the AFR interest rate and the interest rate, if any, actually charged. Basically, the corporation is treated as transferring imputed payments to you.

These payments are considered either taxable compensation (which is acceptable) or a taxable dividend (which is bad). Then, you are treated as transferring the imputed amount back to the corporation as interest (which you may or may not be able to deduct, depending on how you use the borrowed funds).

To avoid the dividend scenario, your corporation’s minutes should specify that any imputed payments from the corporation to you under the below-market interest rules are to be considered employee compensation. (This presumes that you are a bona fide employee and your total compensation is reasonable.) With this strategy, your corporation gets a compensation deduction for the imputed payment to you, thus offsetting the company’s imputed interest payment from you.

Conclusion

As you can see, there are plenty of things to think about when arranging a corporation-shareholder loan. With careful planning, the IRS can usually be kept at bay. On the other hand, poorly documented loan transactions will almost certainly open up a can of worms if either you or the corporation gets audited.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.