By David M. Kendrick, CPA, MST

Loans between shareholders and their closely held S corporations are fairly common.  Shareholders may require an advance from the corporation or the corporation may need a temporary cash infusion to meet expenses.  While this is a legitimate business practice, if a corporation issues a below-market loan, the lender's payment may be reclassified by the IRS as a dividend or other taxable income rather than a bona fide loan which usually results in adverse tax consequences.

The courts have considered a variety of factors in determining what constitutes a bona fide shareholder loan.  These factors include the payer's intent, the requirement of repayment, the existence of a documented note, a stated interest rate, a reasonable maturity term, the shareholder’s level of control over the corporation, and the ability of the shareholder to repay the loan.  Keep in mind that while you may be the sole shareholder of your S-corporation, it is still a corporation, a separate entity for legal and tax purposes and transactions need to be made in a professional, arms-length manner in order to be respected by the IRS.  Now may be a good time to clean-up the books and settle shareholder loans.

Settling shareholder loans:
There are a number of options to settle shareholder loans and advances.  The most straightforward is repayment of the amount either in full or in accordance to the terms of the note; generally, this doesn’t cause adverse tax consequences.  Another option is to have the S corporation forgive the debt and treat it as a distribution to the shareholder.   Although this may be considered a taxable event,  if the shareholder has sufficient basis in his stock, it will be considered tax-free and reduce the shareholder’s “stock basis”.  However, if this basis is reduced below zero, the excess distribution is treated as taxable income subject to the long-term capital gain tax rates.

Tax Consequences:
Paying tax in 2012 to eliminate old loans due to lack of sufficient basis could be a smart move since capital gains rates are 0% - 15%.  These rates are schedule to increase to 10% - 20% in 2013.  It’s also possible that an additional Medicare tax of 3.8% will apply!

The structuring of shareholder loans and distributions and forms of compensation can be complex and costly if not done properly.  Please contact our office for assistance in achieving the best tax result for you and your closely held business.