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, the 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, but the Internal Revenue Service could also determine that the disproportionate distributions created or indicated the second class of stock.  As an S corporation, there can only be one class of stock, and thus, the 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 a 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, that 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 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.