Loans must have a note and pay interest
Loans between shareholders to closely held corporations are subject
to special tax scrutiny and, if not properly documented, will be treated
as either distributions to a shareholder or contributions to the capital
of the corporation. Either way, the tax results can be adverse.
Loans from corporations to shareholders are the subject of an IRS
Market Segment Specialization Plan Audit Guide. The IRS also continues
to vigorously litigate the status of losses from shareholder loans
to closely held corporations. Either way, loans from or loans to,
these arrangements must meet certain minimum standards. Here's a list
of the most important ones.
- Loans must be evidenced by a written unconditional promise to pay.
- Loans must be due on demand or on a stated due date.
- A rate of interest must be stated or determinable by reference to
a published rate.
- The borrower must be creditworthy.
- Payments of principal and interest must be commercially reasonable
for years, while interest accrues does NOT meet the standard).
- A source of repayment other than future income should be clearly
identified and a
collateral interest established.
Protecting the classification of a loan can mean the difference between
ordinary loss and capital loss treatment when a shareholder loan to
a corporation cannot be repaid. Going the other way, payments to a
shareholder that are not well documented as loans can be reclassified
by the IRS as distributions - - taxable dividends or distributions
in excess of basis taxable as capital gains. Either way, these are
bad outcomes for the individual shareholder.
Now is the time to clean up loan documentation and start making regular
payments of principal and interest. In some cases, it may be advisable
to borrow from a bank and pay off shareholder loans for a period of
two or three months. That would be good evidence that the amount was
a bona fide loan.
We can assist you with proper loan documentation and can help you
protect your transactions from IRS attack. Call for an appointment
to discuss the specifics of your shareholder loans.