Borrowing money from your corporation is a viable way to get your hands on some cash without triggering a current tax liability. Of course, the transactions must be structured as a legitimate loan, with repayment terms and all the necessary paperwork.
It’s important to plan ahead when you borrow a large amount of money from your corporation for whatever reason — to buy a house, make home improvements or pay college costs. If you don’t follow all the rules and are audited, the IRS may claim you actually received a taxable dividend or compensation payment rather than loan proceeds.
The good news is that your corporation can currently lend you money at low interest rates with the approval of the IRS. Here’s an explanation of the tax laws involved with corporate loans and how you can benefit by knowing them:
When a firm loans money to a shareholder, a complicated set of below-market loan rules apply unless:
- All loans from the corporation to the shareholder add up to $10,000 or less.
- The corporation charges the shareholder what the IRS considers an adequate rate of interest.
An “adequate” interest rate means the “applicable federal rate” (AFR) or higher.
Key Point: As long as the corporation charges at least the AFR, the loan is completely exempt from the below-market loan rules, which are described in the box to the right and should generally be avoided whenever possible.
Since the current AFR is relatively low, there’s very little reason not to charge it on corporation-to-shareholder loans.
Determine the Proper Rate
The AFR depends on whether the loan in question is a demand loan or a term loan. A demand loan is a loan that’s payable in full at any time on the demand of the corporation. A term loan is a loan that is not a demand loan. For example, a 10-year loan repayable in installments is a term loan.
So, let’s say the AFR was 1.66 percent for short-term loans of less than three years. A corporation could make a 30-month term loan to a shareholder and charge that interest rate over the entire loan term. The loan would be completely exempt from the below-market loan rules.
AFRs change every month and are announced by the IRS in its Internal Revenue Bulletins. (Click here for the current AFRs.) It’s important to note that the AFR for a demand loan is not fixed at the time the loan is made. Also, calculating the correct AFR for a demand loan can be tricky. Therefore, term loans are generally preferred for corporation-to-shareholder loans, as long as the interest rate at least equals the AFR.
How Below-Market Loan Rules Work
When money is loaned by a corporation to a shareholder at an inadequate interest rate (meaning below the AFR), additional interest must generally be “imputed” under the below-market loan rules. In other words, the IRS calculates the interest you should have charged but didn’t. How?
- The imputed interest amount is first deemed to be transferred from the corporation to the shareholder as either an imaginary dividend or as imaginary salary. In either case, the imaginary amount must be reported as additional taxable income on the shareholder’s return. If the amount represents additional salary, the corporation must pay applicable employment taxes.
- The same imputed amount is then deemed to be re-transferred back from the shareholder to the corporation as imaginary interest paid on the loan. This interest income must be reported as additional taxable income on the corporation’s return. (The shareholder may or may not be able to deduct the interest expense, depending on how the loan proceeds are used.)
Calculations to figure the exact amount of imputed interest and the exact timing of deemed transfers between a corporation and shareholder depend on whether the loan is a demand loan or a term loan. The calculations can be very complex.
Implement Favorable Loan Strategies
Given the relatively low AFRs that currently apply, here are three appropriate strategies to consider for corporate loans to shareholders:
- Consider issuing new loans to shareholders that charge exactly the AFR. The complicated below-market loan rules are thereby avoided, and the shareholder is allowed to pay an extremely low interest rate.
- Get rid of existing higher-interest loans by having the shareholder pay them off. Then, replace the old loans with new ones charging low interest rates equal to the current AFR.
- Even if there are existing loans, now is also a great time to pay them off and replace them with new loans that charge the current low AFR. That way, the below-market loan rules are avoided from now on.
As you can see, the tax laws involving shareholder loans are full of twists and turns. If you only need a small amount of money, for example, you may be able to take a de minimis loan of up to $10,000 without paying interest. You can only take advantage of this exception to the general loan rule if the amount of loans outstanding falls within that range. If the amount goes above $10,000 — even for a short time — you need to pay interest at what the IRS considers an adequate rate to avoid tax complications.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout North Carolina including Charlotte, Raleigh/Durham, and Greensboro, with a team of more than 45 professionals serving more than 130 companies throughout the region.