Many business owners make loans to, or take loans from, their corporations and partnerships.  But if care isn’t taken, such loans can cause costly tax or legal problems even when they are made for perfectly legitimate purposes.

Loans to the Business

While an S-corporation’s and partnership’s income and losses are deducted on the personal tax returns of its owners, losses are deductible by them only to the extent of their basis.  Basis generally equals the amount paid to purchase stock shares plus the amount of loans made to the business plus items of income minus losses and expenses.

Owners of S corporations and partnerships who intend to deduct losses in 2004 should check now to be sure they have sufficient basis to do so.  If not, they may want to loan funds to the company by year-end to increase it.

·        The owners of any corporation that needs funds may prefer to loan funds to it rather than make a capital contribution in exchange for more stock.

o       When the need for funds passes, the owner can get the money back from the company tax free through loan repayments-only to the extent of the owner’s basis of the loan.  (Amounts repaid in excess of the basis will be taxable).  In contrast, if the company later “repays” the same amount to the owner through a dividend, it will be taxable. 

o       Advancing funds to the business through a loan is less risky since the claims of lenders receive higher priority than those of shareholders, and get paid off first.

In Bankruptcy, for example, lenders to a business may be fully or partially repaid while its shareholders have the lowest priority.  If nothing is repaid, a larger loss deduction may be available from a loan than a capital contribution.  If you loan funds to your company to protect your job by keeping the company running, and it fails anyhow without repaying you, the full amount of the loan may be deductible against ordinary income as a bad debt under employee business rules.  Unfortunately, this method has been ruled on inconsistently by the tax courts.

In contrast, if you advanced the same funds to the corporation as a capital

 contribution, your loss of them would be less valuable capital loss used to offset capital gains, with only $3,000 deductible against ordinary income annually.  However, there is a $100,000 ordinary loss available on a married-filed-jointly tax return for section 1244 stock, if the stock qualifies.

A major risk when making loans to your corporation is that at a later date the IRS, or bankruptcy court if the business fails, may rule that the loans were not genuine but were, in fact, a disguised contribution to capital.  In which case, all the advantages described above of making a loan are lost.  Loan repayments may be deemed taxable dividends.  And if the business hits hard times, priority status as a creditor is lost, as are potentially larger deductions for un-repaid amounts. 

Two mistakes company owners frequently make when loaning funds to their businesses are being careless with documentation and “forgetting” the loans and not following through on the loan terms.  Formalities are extremely important in transactions between related parties, such as a corporation and its owners.  If the loan terms are not fully documented and followed in practice, the IRS and courts may decide there was no genuine loan at all. 

Fully document any loan with a note and in the corporation minutes.  Set a market rate of interest and a repayment schedule.  Then follow the terms of the loan, making scheduled payments.  If the company has financial hardship and falls behind on making repayments, act as any creditor would-make formal demand for payment and take legal action to obtain it-to protect your creditor status.  If you fail to do so, and instead act like a shareholder facing a stock loss, the IRS and courts may decide that’s what you are.

Loans from the business

There’s an easy-to-understand attraction to taking a loan from one’s own corporation when it possesses ready cash-it is legal, tax-free way of taking money out of the business.  Loan proceeds are not taxed in income as are compensation and dividends.

Once again, the IRS is suspicious of loans between “related parties,” such as a corporation and its owner.  If it concludes a loan isn’t genuine, it can deem the proceeds to be taxable as a dividend or compensation-applying back taxes and penalties.  Again, the way to protect a loan’s status is to fully document it, set market terms, and follow the terms. 

Small businesses often fall into another scenario.  After first receiving legally tax-free money from their business, owners often want more.  After all, why pay tax on money from a business when it is perfectly legal to take the money out tax-free?  Loans from a business can become kind of “Devil’s candy,” with one leading to another, distributing tax-free funds among business’s owners and their family members until total loan amounts equal a significant portion of the value of the business and/or wealth of the borrowers.  This can result in:

·        Inability to sell the business.  Excessive loans may complicate a future attempt to sell the business.  Large debts owed to the business by a selling owner may be of dubious value on the business’s balance sheet in the view of potential buyers-and the seller may not be able to afford to pay them off. 

·        Loss of creditworthiness.  Large loans to owners who have limited ability to repay them may impair the business’s general credit standing and its ability to borrow should the need arise.

·        Accumulated earnings penalty tax.  When a regular corporation accumulates more than $250,000 in earnings that aren’t used in the business, the IRS may impose a penalty tax.  Large personal loans made to shareholders represent just such earnings, if the company can’t prove that the retained earnings are needed for valid business purposes.

Moreover, the fact that loans are made in excessive amounts can by itself turn legitimate loans into disallowed ones, for tax purposes.  A federal Court of Appeals said in just such a case,             “Whereas withdrawals of reasonable amounts are counteranced as a loan if other loan factors are present, excessive and continuous diversion of corporate funds into the controlling shareholder’s pocket take on a different character.  Phrased colloquially, when a pig becomes a hog it slaughtered.”  (Roger Dolese, CA-10, 605 F.2d at 1154.)

Even if the form of genuine loans is followed, loans can result to be deemed dividends or compensation, with big income tax bills resulting to borrowers.  In the case of compensation, a bill for back employment taxes, penalties, and interest is imposed on the business as well.