In today's economy, it's tempting to take a loan from your corporation, but if you don't handle it properly, you could end up owing the IRS more than you bargained for.
People borrow money from their corporation for a variety of reasons-to buy a house, make home improvements or pay college costs. If you don't follow all the rules and are audited, the IRS may claim you actually received a taxable dividend or compensation payment rather than loan proceeds. If successful, the IRS would be able to recharacterize the tax-free loan proceeds as taxable income.
However, if properly structured, borrowing money from your corporation can be a viable way to access some cash without triggering a current tax liability. Of course, the transactions must be structured as legitimate loans, with repayment terms, adequate interest, proper recordkeeping and all the necessary paperwork to comply with the IRS's related-party loan rules.
Related-Party Loan Rules
When a corporation lends money to a shareholder without an adequate interest rate, the IRS will impute additional interest under the below-market loan rules. In other words, the IRS calculates the interest you should have charged, but didn't. This calculation is determined as follows:
The imputed interest amount is first deemed to be transferred from the corporation to the shareholder as either a dividend or salary. In either case, the amount must be reported as additional taxable income on the shareholder's return. If the amount represents additional salary, the corporation must pay applicable employment taxes.
The same imputed amount is then deemed to be re-transferred back from the shareholder to the corporation as interest paid on the loan. This interest income must be reported as additional taxable income on the corporation's return. (The shareholder may be able to deduct the interest expense, depending on how the loan proceeds are used.)
Determination of the exact amount of imputed interest and the exact timing of deemed transfers between a corporation and shareholder depend on whether the loan is a demand loan or a term loan.
Properly Structuring the Loan
When a corporation loans money to a shareholder, the below-market loan rules apply unless all loans from the corporation to the shareholder add up to $10,000 or less, or the corporation charges the shareholder what the IRS considers an adequate rate of interest. An adequate interest rate means the applicable federal rate (AFR) or higher. As long as the corporation charges at least the AFR, the loan is completely exempt from the below-market loan rules.
The AFR depends on whether the loan is a demand loan or a term loan. A demand loan is payable in full at any time on the demand of the corporation. A term loan is a loan that is not a demand loan. For example, a 10-year loan repayable in installments is a term loan.
AFRs change every month and are announced by the IRS in its Internal Revenue Bulletins. It's important to note that the AFR for a demand loan is not fixed at the time the loan is made, and calculating the correct AFR for a demand loan can be tricky. Therefore, term loans are generally preferred for corporation-to-shareholder loans, as long as the interest rate is at least equal to the AFR.
Given the relatively low AFRs that currently apply, here are some appropriate strategies to consider for corporate loans to shareholders:
Consider issuing new loans to shareholders that charge exactly the AFR, which voids the below-market loan rules, and allows the shareholder to pay a relatively
low interest rate.
Get rid of existing higher-interest loans by having the shareholder pay them off. Then, replace the old loans with new ones charging low interest rates equal to the current AFR.
Even if there are existing below-market loans, now is also a great time to pay them off and replace them with new loans that charge the current relatively low AFR. That way, the below-market loan rules are avoided from now on.
If you only need a small amount of money, you may be able to take a de minimis loan of up to $10,000 without paying interest. You can only take advantage of this exception to the general loan rule if the total amount of loans outstanding falls within that range. If the amount goes above $10,000, even for a short time, you need to pay interest at what the IRS considers an adequate rate to avoid tax complications.
The tax laws involving shareholder loans are complex and, if not properly followed, can create tax exposure for shareholders. However, with proper planning, they can provide corporate shareholders with a tax-efficient way to access cash.
Karl A. Heafield, CPA, MST is a tax principal at Baker, Newman & Noyes in Manchester. His practice focuses on providing tax planning and compliance services to businesses and their owners. For more information, visit www.bnncpa.com.