How to Properly Structure Shareholder Loans to C Corporations
June 28th, 2014 at 2:35 PM
Shareholders often loan money to their corporation in order to keep the business operating. There are rules and regulations in the Internal Revenue Code (IRC) that must be adhered to in order for loans to be treated as such, and not an equity contribution.
When a shareholder makes a loan to a corporation, the loan is classified as a Demand Loan or Term Loan. A Demand loan is defined in IRC Section 7872(f)(5) as:
- A loan that is payable in full any time at the demand of the lender, or
- To the extent defined by the regulations, a loan with an indefinite maturity.
A Term Loan is defined in IRC Section 7872(f)(6) as any loan that is not a demand loan.
Now, let’s discuss the various tax differences of using debt vs equity:
- Debt repayment by the corporation is not an earnings distribution to the shareholder, and therefore it is tax-free
- Dividend distributions are not deductible by the corporation, whereas interest payments are deductible under IRC Section 163
- Dividend distributions are taxable to the shareholder to the extent of the corporation’s current or accumulated earnings and profits (IRC Section 301(c)(1). Distibutions in excess of earnings and profits are not taxed, and are treated as a return of capital to the extent of the shareholder’s basis in the corporation’s stock (IRC Section 301 (c)(2). Distributions in excess of the shareholder’s basis are taxed a a capital gain ( IRC Section 301(c)(3)], if the stock is held as a capital asset, and if the corporation is not a collapsible corporation (IRC 341)]. Interest payments are always fully taxable to the recipient shareholder [IRC Section 61 (a)(4)].
- The presence of debt may allow the corporation to accumulate earnings without subjecting itself to an accumulated earning tax ( IRC Section 531)
- If the issuing corporation’s debt becomes worthless, the debt holder’s loss may capital or ordinary depending on whether the debt is a business or nonbusiness bad debt ( IRC Section 166). If the corporation’s stock becomes worthless, a shareholder is generally entitled to a capital loss IRC Section 165(g)(3)]. In some small business corporations, an ordinary loss may be available (IRC Section 1244)].
If the IRS re-characterizes a purported loan from a shareholder to be a capital contribution, the following occurs:
- The Corporation loses its interest deduction-reclassified as a dividend distribution
- Principal payments thought to be tax-free to a shareholder become taxable dividend income, provided sufficient earnings and profits exist
- If the corporation has no current or accumulated earnings and profits, the payments to shareholders will be first a return of capital, then capital gain if the basis is exceeded.
The debt vs equity question is one of the oldest in taxation, and the courts have ruled many times on this issue. No single factor decides the case, but the following factors attribute to the classification:
- Is there a formal promissory note?
- Is there a fixed obligation to pay interest?
- Are there regular and timely payments of interest?
- Is the debt/equity ratio more than 4 to 1–thin capitalization
- Is debt payment contingent on profits
The IRS uses a Market Segment Specialization Guide when conducting audits. One should be familiar with this document, if engaged in the practice of lending funds to their C Corporation.
In summary, the question to ask yourself is, can you go to a bank and borrow money without signing a note which states an interest rate and repayment schedule. We all know the answer to the rhetorical question. To avoid reclassification of loan repayments to dividend income, be cognizant of the rules and regulations cited in this brief article.