As the owner of a closely-held corporation, you may occasionally borrow money from the corporation to tide you over. But you should be aware that casual borrowings from the corporation can have unexpected—and unpleasant—tax consequences.
While you may intend to pay back the money, the IRS may not take your word for that. It may contend that the “loan” is simply a straight distribution from the corporation. While loans are not taxable to the borrower, corporate distributions generally are.
If you operate your business as a regular C corporation, distributions may be taxable as dividends to the extent of your corporation’s earnings and profits. If you operate your business as an S corporation, distributions may be taxable if they exceed your investment in the corporation.
How can you avoid having a loan tagged as a distribution? The more a borrowing looks like a bona fide loan—the kind strangers make with each other—the better its chances of surviving IRS scrutiny. For example:
- Is there a loan agreement in writing with a fixed repayment schedule?
- Is there an interest charge on the loan?
- Did you provide security for the loan?
- Were you in a position to repay the loan?
- Did you actually make repayments?
Even if the IRS acknowledges that the loan is not a corporate distribution, that’s not necessarily the end of the story. If insufficient interest is charged, you may have to pay a tax on the interest shortfall. A special tax rule treats the shortfall itself as a corporate distribution. It’s as if the corporation charged you full interest and then distributed cash equal to the shortfall, which you used to pay the interest.
However, the special rule does not apply if your loans from the corporation do not exceed $10,000 and if tax avoidance is not the principal purpose of the loans. And, depending on the situation, you may be entitled to an interest deduction.
If you want more details on how the tax rules can impact your corporate loans, please contact us.
