Attempting to Avoid Shareholder Loan Reclassification

Many corporate shareholders may have taken a loan from their corporation.  In a prior article we discussed issues related to corporate loans and issues considered regarding the reclassification of a loan.  The article below discusses issues and actions a shareholder may consider taking to prevent the reclassification of a loan.  Please remember that this article is for informational purposes and it is recommended that you discuss any corporate loan issue directly with your tax attorney, business attorney or other advisors.

Proper recordkeeping and maintaining current promissory notes are of extreme importance regarding this issue.  The promissory notes must be kept current and reflect the payments that have actually been made by the shareholder to the corporation, the accrual of interest and other related issues in the previously executed notes.  Moreover, the approval of the loans should follow the proper approval and acceptance by the corporation’s board of directors and memorialized via the corporate minutes and other corporate memorandums.  The shareholder should also be able to verify that the interest has been paid on the note, the interest should be paid at regular intervals, and at least on an annual basis.  Contemporaneous evidence is always important when verifying loan payment and loan treatment to the Internal Revenue Service. From a tax return perspective, the corporate tax return should accurately reflect the loan on the balance sheet.

Because payment of the loan is such a vital factor, I often find it can be helpful to have multiple options or strategies for repayment.  Of course, the shareholder can make regular payments on a monthly, quarterly or yearly basis, but there are also other options for repayment.  If the corporation has strong earnings and profit, the shareholder could also use a distribution to pay make payment on the loan, perhaps even a lump sum payment to expedite payment on the note.  The shareholder may also be able to provide additional services to the corporation and receive bonuses for their work.  These bonuses could be paid to the shareholder and then paid to the corporation, or at least taxed to the shareholder as compensation and then reduce the amount of the note.

In short, generally the most important issues will be recordkeeping from corporate documents such as minutes, agreements and returns to the actual promissory note and making sure the shareholder is making payments with interest on the loan.

John McGuire is a tax attorney and business attorney at The McGuire Law Firm.  John assists clients with matters before the IRS, tax planning and advice, and business matters from contracts to the sale of business assets and interests.

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