Tax Treatment of Shareholder Loans

In some circumstances, a closely held business might advance or loan money to a partner for non-business expenses and is common in construction companies with a small number of shareholders. But it’s important to know how to treat the loan receivable to avoid it being classified as additional taxable compensation to the shareholder, subject to employment taxes, or possibly a constructive dividend subject to ordinary or capital gains tax rates.  First, let’s look into why this situation would occur.

Why would a shareholder borrow money from a company as a loan receivable?

Here are a few common examples of why the loan receivable may occur:

  • The shareholder is using company funds for personal expenses and reflecting them as a loan
  • The shareholder needs to borrow company funds for business or non-business purchases
  • The shareholder wants to ensure there are not distributions in excess of basis at the end of the tax year, so a reclassification as a receivable is booked

How can you avoid a taxable event?

To determine if the receivable is really a loan and to avoid creating a taxable event, certain factors need to be considered, including:

  • How much control does the shareholder have in the corporation?
  • Does the shareholder have the ability to repay the debt without additional corporate funds?
  • Has the corporation setup and documented a formal note with the shareholder taand enforced collection of the receivable?
  • Does the corporation have prior S Corporation accumulated earnings and profits which may be indicative of a constructive dividend distribution rather than a bona fide loan?
  • Does the company history, or lack thereof, for paying dividends indicate the payments could be for dividend distributions rather than loans?
  • Is interest being paid on the loan at market rates? If not, this could also result in additional taxable income to the shareholder.
  • How has the receivable been reported on the company’s financials provided to the surety?
  • Did the shareholder report the liability to the company on their personal financial statements provided to the bank?
  • Is the shareholder receiving reasonable compensation for the services being provided?

Once you’ve determined the loan can be categorized as a loan receivable on the balance sheet, it should be properly documented with a formal note using appropriate interest rates and repayment terms. Most importantly, it should be determined that the loan can and will be fully repaid to the company.

Being able to utilize company funds for various purposes can be a benefit to the shareholders of a closely held business, and are sometimes necessary. If you have questions or would like to discuss your situation, please contact an Anders advisor.