Often times a payment or payments to S corporation shareholders will be booked or accounted for as a loan to shareholder. Sometimes this is purposefully, other times, it may be due to lack of options. These loans can be advantageous with the proper planning and/or under certain circumstances, but they can also create and lead to unintended and disadvantageous tax consequences.
If a loan is not being treated as a loan (documented, repayment with interest etc.) the loan can be reclassified as a distribution to the shareholder. If the shareholder does not have enough tax basis in their stock, taxable gain will result when the loan is reclassified as a distribution. Further, it is important to note that if a loan is reclassified as a distribution and there are multiple shareholders, the distribution could create disproportionate distributions amongst the shareholders. Not only could the disproportionate distribution be a violation of certain law/business acts, the Internal Revenue Service could determine that the disproportionate distributions created or indicate a second class of stock. As an S corporation, there can only be one class of stock, and thus, a second class of stock could/would result in the termination of the S corporation election, which could have ill intended tax consequences and other business consequences.
Given the above, what can be done in an attempt to prevent payments or disbursements to a shareholder from being treated as distribution, but rather a loan to the shareholder? Generally speaking, the key is proving intent, that the disbursements were intended to be a loan or loans. Below is a list of the issues and factors a court would likely consider when making a determination of whether or not a shareholder loan was in fact created.
- Was the shareholder paying interest? It is also important to note, the IRS can impute interest under the Internal Revenue Code.
- Is the amount/loan being repaid by the shareholder?
- Is the debt evidenced by a written instrument such as a promissory note, with stated interest, payment terms & conditions and a maturity date?
- How has the disbursement to the shareholder been recorded and reflected within the S corporation’s books
- If the shareholder was in arrears of any payment, did the corporation attempt to enforce or require payment
- Did the shareholder have the financial wherewithal to repay the note when the loan was provided by the corporation
Of all the above issues & factors, perhaps the most important is whether or not the shareholder was actually repaying the loan. Courts have determined a loan existed even without documentation and promissory notes given the shareholder was making payments.
The above article has been prepared by John McGuire of The McGuire Law Firm for informational purposes. John focuses his practice on tax matters before the IRS, advising individual & business clients on tax planning and tax related issues and business transactions from business formation and contracts to the sale of a business or business interest.