It’s quite normal for closely held businesses to transfer money into and out of the company. But it’s critical that you make those transfers correctly. If you don’t, you might run up against the Internal Revenue Service — the IRS looks closely at how such transactions are characterized: Are they truly loans or an advance?
Loans might be the best route
When an owner withdraws funds from the company, the transfer can be characterized as compensation, a distribution or a loan. Loans aren’t taxable, but compensation is and distributions may be taxable.
And if the company is a C corporation, distributions can trigger double taxation — in other words, corporate earnings are taxed once at the corporate level and then again when they’re distributed to shareholders (as dividends). Compensation is deductible by the corporation, so it doesn’t result in double taxation. (But it will be subject to payroll taxes.)
If the business is an S corporation or other pass-through entity, there’s no entity-level tax, so double taxation won’t be an issue. Still, loans are advantageous because:
- The compensation is taxable to the owner (and incurs payroll taxes), and
- The distributions reduce an owner’s tax basis, which makes it much harder to deduct business losses.
There are also some advantages to treating advances from owners as loans. If they’re treated as contributions to equity, for example, any reimbursements by the company may be taxed as distributions.
Loan payments, on the other hand, aren’t taxable, apart from the interest, which is deductible by the company. A loan may also give the owner an advantage in the event of the company’s bankruptcy, because debt obligations are paid before equity is returned.
Is it a loan or not?
It’s important to establish that an advance or a withdrawal is truly a loan. Simply calling an advance or a withdrawal a “loan” doesn’t make it so. If you don’t make that distinction, and the IRS determines that a payment from the business is really a distribution or compensation, you (and, possibly, the company) could end up owing back taxes, penalties and interest.
Whether a transaction is a loan is a matter of intent. It’s a loan if the borrower has an unconditional intent to repay the amount received and the lender has an unconditional intent to obtain repayment.
Unfortunately, even if you intend for a transaction to be a loan, the IRS and the courts aren’t mind readers. So it’s critical that you document any loans and treat them like other arm’s-length transactions. Among other things, you should execute a promissory note and charge a commercially reasonable rate of interest — generally, no less than the applicable federal rate (AFR).
You should also establish and follow a fixed repayment schedule and secure the loan using appropriate collateral. (This will also give the lender bankruptcy priority over unsecured creditors.) And you must treat the transaction as a loan in the company’s books. Last, you must ensure that the lender makes reasonable efforts to collect in case of default.
Also, for borrowers who are owner-employees, you need to ensure that they receive reasonable salaries, to avoid a claim that loans are disguised compensation.
The bottom line
The IRS keeps a wary eye on businesses that wish to lend or borrow from themselves. So it’s critical that you retain a qualified advisor. He or she can lead you through the minefields of borrowing from your company.