Corporate Loans Are A Valuable Tool–Here’s How To Properly Structure Them

May 26th, 2014 at 10:44 AM

C Corporations owners have a double-taxation problem. Here’s why:

Suppose your C Corporation has $10,000 of profits after paying your salary and other expenses. To move those funds to your personal account, you have to:

1. pay the corporate tax on the income, and
2. pay a dividend tax on the transfer from the corporation to your account.

That’s double taxation, and a poor tax planning solution. However, by structuring this transaction as a corporate loan, the tax on the dividend can be avoided.

If you borrow the $10,000 instead of taking the distribution, you can repay the loan at a tax cost of approximately $9.81 a year. Compared to the dividend of $1500, this is a much better solution.

But before you take the loan, you need to know the rules, or the IRS will re-characterize the transaction as a dividend.

Here’s How

When you structure this transaction as a loan, you must have documentation; the paperwork needs to look like loan documents that are created with a bank or unrelated third party. When courts consider these cases, they determine whether there’s a likelihood that you will actually repay the money that is borrowed. Here are the primary considerations the courts focus on:

1. Are there loan documents between you and the corporation? They should include a promise to repay the funds, a schedule for repayment, and an interest rate.
2. Did you actually make loan payments, and were they timely. Courts hear these cases long after you take the loan, so they will know whether you adhered to the agreement.
3. Do you earn ample income to pay off the remainder of the loan.
4. Did the corporation treat you as an unrelated party by investigating your credit or income before lending the money? Was there collateral, was there penalties for late payments?

On one case that the author researched on this topic, the taxpayer did not fill out a single loan document. But, he did have the following factors on his side of the ledger, that proved to be sufficent to win his case:

1. He made a large repayment of the principal.
2. He paid interest.
3. He had a large salary, which led the court to believe he was likely to repay the balance of the loan.
4. The corporation’s minority shareholder testified that the payments were a loan. This is an essential fact because unrelated shareholders have an interest in forcing repayment-otherwise the value of the corporation declines without giving the unrelated shareholders any benefit.

When you are in a loan situation with a related party, such as your corporation, make sure you adhere to the factors in this article. Its far less expensive than hiring a lawyer, and going to court.