How Loans From Owners Of S Corporations Will Change Your Tax Reporting
FAS CPA & Consultants
If you are part of an S corp, your shareholder assets are protected, and you have the benefit of pass-through taxation, amongst other advantages. However, when the corporation requires some financing, it can take a long time to secure a business bank loan. A shareholder loan might just be what the doctor ordered as long as the parties consider the tax implications with due care.
Capital Contributions Or Shareholder Loan
A shareholder can elect to make a capital contribution and buy additional shares in the corporation, or the shareholder can make a loan to the S corp. Both ways will result in an increase in the shareholder’s basis in the S corp. Paid-in capital (capital contribution) increases the shareholder’s stock basis, and a loan increases the debt basis. Basis is vital for shareholders to deduct pass-through losses equal to the amount of their basis in the corporation. Once a shareholder’s pass-through income exceeds their basis, the income becomes taxable.
The classification of contributions (as capital or a loan) and its impact on the shareholder’s stock or debt basis can have diverse ramifications on the shareholder’s taxes as well as on the setup and repayment of the contribution.
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A Loan Or A Capital Contribution
Where the s-corp needs money urgently and cannot wait for a bank loan, or needs a short-term infusion only, a loan from a shareholder makes much sense.
When there are multiple shareholders, the IRS requires all distributions from the corporation to the shareholder to be pro-rata. No individual distributions to any specific shareholders are possible.
If the corporation has to repay one of the ten shareholders an amount of $3,000, it will have to wait until it has $30,000 available. Even for partial payments, all shareholders must receive the same amount. For any shareholders who made extraordinary capital contributions, this won’t do.
A shareholder’s loan has an advantage over this: the corporation can pay only the shareholder who made the loan. The shareholder who made the credit available can get his money back faster, and the S corp needs only $3,000 available rather than $30,000.
Drafting A Debt Agreement
The IRS carefully watches S-corps to ensure that their pass-through taxation does not avoid payroll and shareholder income taxes. Shareholders pay taxes on all profits made from selling stocks, and dividends (assets paid out from profits taxable as income for stockholders in the year of distribution).
Loans made by shareholders to the s corp enjoy the same protection of assets as a third party lender has, as long as the S corp and the shareholder conclude a bona fide debt agreement. A bona fide agreement has the following requirements:
⇒ The parties agreed in writing.
⇒ The agreement states a fair market interest rate.
⇒ The s-corp has to pay back the loan before the stated maturity date.
⇒ The debt is enforceable under state law.
⇒ A reasonable expectation exists that the loan will be repaid.
⇒ There are remedies for any defaults (security interest or position of the lender in respect of other creditors).
⇒ Repayment terms are set out in the agreement.
⇒ Security or collateral was provided for the loan.
⇒ Strict adherence to the loan agreement is essential.
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What is the point of a debt agreement
Example 1:
⇒ Shareholder A has a stock basis of $1,000.
⇒ He decides to make a capital contribution of $2,000 for a new project.
⇒ His contribution increases his stock basis to $3,000.
In respect of taxation:
⇒ He can have losses from the corporation passed through up to an amount of $3,000.
⇒ His $3,000 can be paid back to him free from taxation.
Example 2:
⇒ Shareholder A has a stock basis of $1,000.
⇒ He decides to make a loan to the corporation of $2,000 for a new project.
⇒ He now has two tax bases, $1,000 for stock and $2,000 for debt.
In respect of taxation:
⇒ If losses reduce the stock basis to zero, future losses can be applied to the debt basis.
⇒ If losses of $3,000 are incurred in the same tax year, the stock basis and debt basis reduce to zero.
One year later:
⇒ With his tax basis and debt basis reduced to zero, one year later, the S corp pays the $2,000 loan back to the shareholder.
⇒ In the absence of a loan agreement, the $2,000 repayment of the loan has to be reported to the IRS as income, and the LENDER must pay income tax on the repayment.
⇒ With a debt agreement in place, the repayment is considered capital gains and taxed at a lower rate.
Example 3:
In respect of taxation:
⇒ If the S corporation makes a loss of $2,000 instead of $3,000, the stockholder’s stock basis is reduced to zero and his debt basis to $1,000.
⇒ When there is a loan in place, the stock basis cannot be increased before the loan is repaid.
⇒ When the debt is repaid, disbursements can be made to the stockholder to get the stock basis back to the original amount.
⇒ Any amount above the original stock basis is deemed to be income.
Loan repayments are typically considered ordinary income. If a debt agreement supports the loan, the shareholder will pay capital gains taxes instead of ordinary income taxes on the reimbursements they receive on the loan.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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