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Owe money to your corporation?
7 signs the IRS looks for to identify shareholder loans vs. taxable distributions.
Lack of proper loan documentation is a recurring issue among corporation shareholders, as well as between related entities under common ownership. The IRS often reviews transfers from corporation to shareholder to see if the available documentation supports its classification as a loan. If it doesn't, the IRS can determine that the loan was actually a taxable distribution, which means the shareholder must make significant tax payments. Failure to follow the tax law as it applies to shareholder loan documentation can result in the shareholder owing thousands of dollars.
These are the seven most common factors the IRS uses when considering the correct classification of a shareholder loan. Review them to determine if your loan meets the IRS's qualifications to keep from being penalized.
1. Promise to repay is evidenced by a note.
A promissory note must be drawn up and signed before any loan is made, and the borrower must follow the note's terms. If a note is signed and its terms are ignored, the IRS may determine that this test failed. This test might also not be met if the note is created or signed after the initial transaction occurs.
2. Interest is charged.
The transaction will not be considered a loan if it is interest-free. This interest must be no lower than the applicable federal rate (AFR) during the month in which the loan is made. These rates are published by the IRS monthly, and once an interest rate is set, it does not have to be adjusted if the AFR increases or decreases. Fortunately, the AFR is lower than the market rate. If a loan is made of less than $10,000 (including interest and fees), this test does not need to be met. In this case, the interest rate can be below the AFR, or even zero.
3. Collateral has been given to secure payment.
The IRS looks at collateral very favorably. While an unsecured loan could easily be viewed as a distribution, it's unlikely that a shareholder would give a corporation collateral to receive a distribution. Registering a security interest in collateral with the jurisdiction's recorder's office provides good evidence of the intent of repayment.
4. A schedule of repayment has been established.
The IRS also looks for a repayment schedule to be laid out before the loan occurs. Usually this takes the form of an amortization schedule, which defines interest and principal portions for each payment. If a repayment schedule is created after the loan is made or after the first payment is due, the IRS may not find this acceptable.
5. Repayments are made.
If the borrower misses repayments, the corporation is expected to charge late fees and attempt to collect the past-due payments. Also, a record of payment needs to be kept by both the shareholder and the corporation. If a shareholder is far enough behind to warrant attempting to collect collateral, the corporation is expected to start that process.
6. Prospect of repayment exists.
There needs to be a reasonable prospect that the shareholder can repay the corporation. If the shareholder has inadequate income to make the payments or is not creditworthy, it may appear as though the corporation never expected the loan to be repaid.
7. Both parties' overall conduct indicates a loan.
If the terms of the note are not strictly followed, it may be determined that the parties do not view the transaction as a loan. Essentially, the corporation should act as any other creditor in this situation. Ignoring poor credit and lack of timely payments creates the appearance of a distribution. Also, the shareholder must act as he or she would if the loan came from a third-party creditor. The shareholder is expected to make every effort to pay what's owed under the terms of the loan. If the shareholder's behavior indicates that this transaction might not have been a loan, the IRS will weigh this factor unfavorably.
A few other considerations: If the note does not have a set maturity date, the IRS may consider the transaction a distribution. A set maturity date that's continually pushed back may be considered meaningless.
Similarly, the IRS will be skeptical of a loan with a growing balance. It's one thing to reduce a loan balance over the course of a couple of years before taking out an additional loan, but if the balance is consistently trending upward, this type of transaction will appear to be a series of distributions.
Finally, the IRS may consider corporate loan history and documented loan ceilings. If the corporation possesses, in writing, a specific per-shareholder loan ceiling that it strictly adheres to, this works in the shareholder's favor. When looking at loan history, the IRS will determine if these transactions occur with the frequency expected from distributions. If loans are sporadic, they look less like distributions.
Following these recommendations can help lead the IRS to conclude that shareholder loans are not shareholder distributions. While there is no guarantee, knowing the factors the IRS considers will enable you to take the necessary steps to protect yourself from unnecessary taxation and financial penalties.
Dr. Heinke is owner of Marsha L. Heinke, CPA, Inc., and can be reached at (440) 926-3800 or via e-mail at MHeinke@VPMP.net.