Black Friday sale: Up to $1400 off bookkeeping, 100% tax-deductible.
Shareholder loans allow you to move money into or out of the business with a catch: it’s paid back with interest. Since it’s structured as a loan, you’ll need to know how to draft the loan, the impact on the business’s finances, and how it affects your taxes.
Different kinds of shareholder loans
There are two types of shareholder loans: loans from shareholders and loans to shareholders.
Loans from shareholders are when a shareholder provides a loan to the business. The business is responsible for paying back this contribution with interest based on a loan agreement. If you have the personal capital to provide the loan, this is an opportunity for the business to get a loan with favorable terms, especially if the corporation doesn’t have an established credit history.
Loans to shareholders are the opposite. The shareholder has borrowed money from the business and is responsible for paying it back with interest. This helps shareholders take out a personal loan from the business instead of going to a bank or other financial institution while the corporation benefits from making some extra money on the interest.
Let’s break down both in depth.
Loans from shareholders
Procedure of the loan
Before you send money to your business, there’s some groundwork that needs to be done ahead of time.
Prior to transferring funds, a written loan agreement needs to be drafted. This agreement must outline the loan as being an “arms-length” transaction. This means that it needs to treat the shareholder and corporation as two separate parties completing a transaction that’s close to what’s available on the market.
The loan needs to be clearly detailed. There has to be an exact loan amount, a predetermined interest rate, and repayment terms including the monthly payments and duration of the loan. While you can set the interest rate, it should be above the Applicable Federal Rate. An interest rate below that would be considered below market value and can create complications by no longer being an arms-length transaction.
You should also draft up an amortization table (also called an amortization schedule). Amortization tables show how much of each payment goes towards principal and how much is an interest expense. An amortization template will help you find the exact numbers.
If you have no prior experience with drafting a loan document, consider using a template or consulting with a professional to ensure you’re meeting IRS requirements.
Impact on taxes
With shareholder loans, there are tax implications for both the corporation and shareholders.
For corporations, the tax implications are similar to a traditional loan. Any interest paid on a shareholder loan is a tax deductible expense—so long as it’s backed up by the loan agreement and amortization table.
For shareholders, any payments towards the principal are not recorded as personal taxable income. However, you must report the interest received in the tax year on your personal tax return. The corporation provides the shareholder a Form 1099-INT which reports the total interest earned.
Impact on debt basis in S corporations
Specifically for S corporations, shareholder loans impact the debt basis of the shareholder.
Debt basis is the amount of debt owed by the S corporation to the shareholder. This basis is temporary and decreases as the corporation pays down the debt or as the shareholder declares the S corporation’s losses on the personal return.
A shareholder’s debt basis works very similarly to a stock basis: the more of a debt basis you hold, the more of the S corporation’s losses you can claim on your personal tax return. But this only applies to an S corporation’s losses, so if the S corporation doesn’t record a loss, the debt basis rolls over into the next year.
For example, if an S corporation has a single shareholder who has provided a $100,000 loan to the company, they have a $100,000 debt basis. If the S corporation records a loss of $60,000, the shareholder can report the $60,000 loss on their individual income tax return to reduce their personal taxes. Their debt basis then reduces to $40,000 ($100,000 - $60,000).
Suggested reading: S Corporation Tax Filing: Benefits, Deadlines, and How-to
Capital Contributions
Capital contributions are when shareholders invest in the company but rather than be paid back like a loan, it increases their equity in the business. This usually takes form as shares or stocks. Since shares or stocks are being issued, it’s important to have the contribution and amount of stocks issued clearly documented.
Capital contributions aren’t taxed. However, the shareholder likely has to pay capital gains if they profit on the sale of that equity in the future.
Let’s say you contribute $10,000 to a corporation in exchange for 1,000 shares, a price of $10 per share. Later, you sell 500 of those shares for $6,000, a price of $12 per share. You’ve gained $1,000 from the sale (a $2 gain per share on 500 shares) and will report the gains on your personal tax return.
Loan to Shareholder
Procedure for the loan
Regardless of whether the loan is to or from the corporation, the transaction needs to be clearly documented before money switches hands.
Just as you would for a loan from a shareholder, a formal written loan agreement must outline the details of the loan. The agreement needs to prove that the loan is an “arms-length” transaction. Essentially, it needs to prove that the corporation and shareholder are acting as two separate parties that are completing a formal transaction in line with what’s available on the market.
All payment terms must be clearly outlined. This includes an exact loan amount, the agreed upon interest rate, monthly payments, and duration of the loan. You can set the interest rate, however it should be above the Applicable Federal Rate (AFR). An interest rate below that could fail to meet the arms-length requirement and potentially trigger an audit.
Draft up an amortization table as part of the process. This will be your exact breakdown of how much of each payment goes towards the balance of the loan and how much is an interest expense. Use an amortization template if you’re unsure how to do so.
There are strict IRS requirements so consider using a template or consulting with a professional if you have no prior experience with drafting loan documents.
Impact on taxes
For both corporations and shareholders, there’s an impact on their usual tax filing process.
For the corporation, they earn interest on the loan. This interest is a portion of each payment that can be considered the “charge” of lending the money and is considered taxable income. It’s the responsibility of the shareholder who took the loan to report how much interest they paid in the tax year.
For the shareholder, they need to fill out and send Form 1099-INT to the corporation. Form 1099-INT outlines any interest paid on the loan. If you’re having trouble figuring out how much interest you paid on the loan as a shareholder, refer back to the amortization table.
Shareholders should also take note of the interest paid for their personal tax return. After all, it’s a tax deductible expense.
The bottom line
In the early stages of a corporation, shareholder loans are helpful for temporarily moving money into and out of the business. So long as you follow the rules, it’s a great way to control the cost of providing capital to either the corporation or the shareholder.
Recording these transactions properly in your books is an essential part of the shareholder loan process. With Bench, you have a team of bookkeepers ensuring all loan activity is accurately recorded and IRS compliant. See for yourself how Bench saves businesses hours of admin work every week with a free personalized demo.
