Whenever cash or property passes between a closely held corporation and its shareholders,  there are generally tax consequences. You can control these consequences by documenting your intentions for the transaction to be considered a corporate loan instead of a dividend and by following through accordingly.

For example, let’s say a shareholder takes a withdrawal from a corporation’s accounts that are intended as a tax-free corporate loan — but the withdrawal is not properly documented. In an audit, the Internal Revenue Service will likely recharacterize this withdrawal as a constructive dividend. This could cause capital gains tax to be due on the shareholder’s individual tax return.

Important factors for a corporate loan

The IRS and the courts examine a number of factors to determine if payments to a shareholder are proceeds from a tax-free corporate loan or a taxable corporate distribution. Some of the factors that they will consider in these situations:

  • Was there a written promise to repay the loan as evidenced by a note or other document?
  • Was there a stated interest rate, repayment schedule or balloon repayment date?
  • Were principal and interest payments made on time?
  • Was there adequate security or collateral for the loan?
  • Did the borrower have a reasonable prospect of being able to repay the loan?
  • Did the parties conduct themselves as if the transaction was a loan? For example, did the shareholder show loans owed to the corporation as liabilities on his or her personal balance sheet?

When transactions are intended to be loans, the factors above should be considered and respected. Otherwise, the IRS could recharacterize the transactions in ways that have negative tax consequences for the shareholders, their corporations, or both.

Plan ahead

Properly structuring corporate loans is critical to getting the best tax and financial results. Contact us for assistance in plotting the best strategy.

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This blog post is designed to provide information about complex areas of tax law. The information contained in this blog post may change as a result of new tax legislation, Treasury Department regulations, Internal Revenue Service interpretations, or Judicial interpretations of existing tax law. This blog post is not intended to provide legal, accounting, or other professional services, and is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services.

This blog post should not be used as a substitute for professional advice. If legal advice or other expert assistance is required, the services of a competent tax advisor should be sought.