Shareholder Loans to a Corporation
Shareholders often loan money to a corporation in order to keep the business operating. However, be aware there are rules and regulations which must be followed, so the loan is treated as a loan, and not reclassified as an equity contribution. These rules can be quite complicated, but if the transaction is structured correctly, you can avoid these rules. This discussion will focus on shareholder loans to a corporation and not loans from a corporation to a shareholder. I have referenced IRC code sections and regulations for reference purposes.
The terms used below: Current Earnings and Profits (CE&P), Accumulated Earnings and Profits (AE&P), and Accumulated Earnings Tax (AET) are only applicable to "C" Corporations (Form 1120) or an "S" Corporation (Form 1120S) which was previously a "C" Corporation. (In other words, if you have been an "S" Corporation since formation, these terms will not apply to you.)
When a shareholder makes a loan to a corporation, the loan is classified as a Demand Loan or a Term Loan. Below is the formal definition of these:
Demand Loan - IRC Section 7872(f)(5) defines a demand loan as: A loan that is payable in full at any time at the demand of the lender, or to the extent defined by the regulations, a loan with an indefinite maturity.
Term Loan - IRC Section 7872(f)(6) defines a term loan as any loan that is not a demand loan.
Section 7872 - Below-Market Loans apply to:
a. Gift loans, b. Employer-employee loans, c. Shareholder-corporate loans, and d. Tax avoidance loan.
When a shareholder makes a loan to a corporation it is classified as a below-market loan (Section 7872). Section 7872 is quite onerous and there are two ways to escape the aggravation of this treatment:
1. $10,000 de minimis rule. Under the $10,000 de minimis rule, an interest calculation is not required.
2. The corporation or shareholder charges at least the AFR (Applicable Federal Rate). With today's low AFR rates, taxpayers should consider rewriting demand loans as term loans to lock in the low rate.
With this in mind, let's discuss the tax differences of using debt versus equity. There are many tax differences between a corporation issuing stock versus debt to its shareholders.
* Debt repayment by the corporation is not an earnings distribution to the shareholder, and therefore it is tax-free.
* Dividend distributions are not deductible by the corporation, whereas interest payments are deductible by the corporation [Section 163].
* Dividend distributions are taxable to the shareholder to the extent of the corporation's current or accumulated earnings and profits [Section 301 (c)(1)]. Distributions in excess of earnings and profits are not taxed, and are treated as a return of capital to the extent of the shareholder's basis in the corporation's stock [Section 301 (c)(2)]. Distributions in excess of the shareholder's stock basis are taxed as a capital gain [Section 301 (c)(3)], if the stock is held as a capital asset and if the corporation is not a collapsible corporation (Section 341). Interest payments are always fully taxable to the recipient shareholder [Section 61 (a)(4)].
* The presence of debt may allow the corporation to accumulate earnings without subjecting itself to an accumulated earnings tax (Section 531).
* If the issuing corporation's debt becomes worthless, the debt holders' loss may be ordinary or capital depending on whether the debt is a business or nonbusiness bad debt (Section 166). If the corporation's stock becomes worthless, a shareholder is generally entitled to a capital loss [Section 165(g)(3)]. For some small business corporations (Section 1244), an ordinary loss deduction may be available.
If the IRS recharacterizes a supposed loan from a shareholder to be a capital contribution the following would happen:
* The corporation loses its interest deduction (reclassified as a distribution).
* Principal payments thought to be tax-free to shareholders become taxable dividend income (provided sufficient earnings and profits exist).
* If the corporation has no current or accumulated earnings and profits, the payments to shareholders will be first a return of capital, then capital gain if basis is exceeded.