Loans are an integral part of most businesses. However, when loans are received from shareholders of the business, additional considerations must be made. Failing to do so can result in reclassifications that can prove costly when filing annual tax returns.
What are reclassifications and their consequences?
When a shareholder makes a bona fide (legitimate and enforceable) loan to a company, their debt basis in the company increases. This allows for the shareholder to receive repayments of principal up to the amount of the ratio of debt basis to the face value of the original loan without any tax consequences. For payments of interest, the shareholder will report interest income on their personal return. Likewise, the company can deduct interest paid on the loan under most circumstance. This normal classification of the loan can be mutually beneficial for both the shareholder and the company itself.
Reclassifications occur when shareholder loans are seen as something other than a bona fide loan by the IRS. While there may be a signed promissory note or other loan document with details of interest to be charged, a repayment schedule, and other terms, it may be meaningless in the eyes of the IRS if the terms are not enforced.
The IRS can reclassify shareholders loans if it is believed that they resemble equity. In other words, this classification considers the shareholder loan to be contributed capital rather than a loan. As such, the shareholder will instead have stock basis in the company. Payments to the shareholder are then considered distributions. This could lead to taxable income for the shareholder to the extent the distribution is more than their stock basis in the company.
How to avoid reclassifications
To avoid reclassifications of shareholder loans, you should consider the following:
- The loan should be documented in writing and carried on the business’ balance sheet.
- A reasonable rate of interest should be charged, and regular payments should be made. The importance of charging interest becomes increasingly relevant with larger loans.
- There should be a specified date of repayment for the loan. Repayment can be structured in installments, a balloon payment, or combination of both.
- Repayment ability should be considered. If repayment does not seem feasible, the loan may be reclassified as equity.
- Finally, the total value of shareholder loans should be considered in relation to contributed capital. If shareholder loans are high in comparison, the IRS may consider the loan to be contributed capital.
Taking these precautions when initiating a shareholder loan can help ensure that the IRS does not reclassify them and thus avoid potentially costly tax repercussions. If you have any questions or need further assistance with shareholder loans, please contact the professionals at Gilliam Bell Moser.