1. Basics of an S Corporation Loan
2. Preventing a Loan Payment From Being Considered as Income
3. S Corporation Shareholders and Distributions

Updated October 6,2020:

Loans to shareholders S corp helps the shareholders when a shareholder needs funds and there's not enough time to get a bank loan. The shareholder can also put money into the corporation when it needs an infusion of cash, but the corporation has to be diligent in repaying the loan so as to avoid incurring taxes for that shareholder.

Basics of an S Corporation Loan

Sometimes an S corporation is short on funds and needs a fast cash infusion. A loan from a bank may not be a viable option, but a shareholder can choose to fund the business out of their own pocket. The benefit of making a loan comes in the form of getting the money repaid without the need to disburse money to other shareholders. However, repayment of the loan has to be handled carefully as it can cause the shareholder to be responsible for taxes on that income. 

The S corporation has the option to pass through losses to the owners. This can be deducted by shareholders to the total amount of their adjusted stock and loan basis. In the event the pass through is more than the shareholder's stock basis, the excess amount of the loss reduces that shareholder's loan basis, but it can't be lowered below zero. 

Here's a potential scenario: an S corporation needs an influx of capital, but the shareholders were too busy to obtain a loan and a critical payment is upcoming. One of the shareholders gives the S corporation a personal loan on the expectation that the corporation will get a loan in the near future and repay the shareholder within a short period of time. Because there is no bank note, the loan is considered to be an open account debt. In the event the corporation passes through net income in a following year, the loan basis is increased, but only to the amount that the company owes the shareholder at the beginning of the tax year. 

If the loan basis is reduced to zero and the entire loan is repaid, the repayment becomes income to the shareholder even though it's a loan repayment. This is due to the fact that the loan has no note and is considered an open account debt. 

Preventing a Loan Payment From Being Considered as Income

If the company anticipates an inability to repay the lending shareholder or there's a pass through loss, that shareholder should create a note for their debt. This way, subsequent debt payments are treated as capital gain instead of regular income and taxed at a lower rate. Another alternative is making the corporation wait to repay the shareholder debt until there is a year with positive net income to restore most or all of the loan basis. Or the shareholder can take out a personal loan that's separate from the business and avoid repayment from the corporation in a year that shows a loss. 

S Corporation Shareholders and Distributions

In the event an S corporation is not paying what is considered to be a reasonable salary to a shareholder who provides their services to the corporation, any distributions to that shareholder may be considered wages which are subject to payroll taxes. One way around this potential classification is lending corporate monies to the shareholder and avoid the double-taxation problem that comes with dividends. 

Defining distributions as loans avoids taxable distributions when a shareholder wants to take cash from the corporation and other accounts don't have enough money to allow a nontaxable distribution. But this loan has to be an actual loan in order to avoid a constructive dividend. And it has to have an adequate interest rate to avoid being considered as dividends per the below-market loan rules of Sec. 7872 under the U.S. Code Title 26. 

Sometimes a loan is viewed as a disguised distribution by the IRS. A corporation has to respect shareholder loans as being true and actual or risk problems that include:

  • Loan being re-characterized as a distribution and causing distributions to be disproportionate
  • Payments to a shareholder for an outstanding loan could be considered an equity investment and payments considered as distributions
