Loaning Money To Your Company

Some things to consider when loaning money to or taking a loan from your own corporation.

In the most rudimentary statements about United States currency, a dollar bill is a dollar bill. The dollar in your right pocket is as equal in value as the dollar in your left pocket. One hundred pennies stuffed in a jar is the same value as a dollar bill in your wallet or purse. A dollar bill in your bank account is the same measure of value as a dollar tucked in a drawer. Further, a dollar that you earned today carries the same face value as the dollar you earned yesterday. On the other hand, one dollar belonging to your company is not the same as a dollar belonging to you personally.

Why is this? Several potential problems can arise when lending or investing money to or from your own corporation. First, as mentioned above, money is money. Corporate money looks no different from a dollar owned personally and therein is the problem. Second, the legal position of a company dollar and a personal dollar are different. Third, the tax position of the dollar is different moving from personal dollar to corporate dollar.

This article will explain the potential problems that must be taken into consideration whenever anyone loans money to his/her own corporation or takes a loan from his or her own corporation.

The Common Day-to-Day Situation
The most typical situation involves an owner who loans money to his/her corporation in order to keep the corporation afloat and has no real intention of receiving the funds back until or unless the corporation has excess funds that it does not need for operating purposes. In situations of this nature, legal documents may or may not be prepared. Unfortunately, the Internal Revenue Service has a policy of reclassifying the debt as equity. This reclassification results in the loss of the company to repay not only the principal of the loan but also any interest due on the loan. For accrual basis taxpayers, even the interest that is accrued must be reclassified as equity. As a matter of fact, the government states that any funds paid to the stockholder that are said to be interest payments will be reclassified as dividend distributions. In such a reclassification, the corporation will lose any tax deduction it might have obtained if the payment to the stockholder had been shown as an interest payment on the loan. Further, the stockholder still must pay taxes on the receipt of the dividend distribution.

An example of this situation typically arises wherein two individuals loan money to their corporation in order for the corporation to purchase an outside entity. The investment by the stockholders is shown as a loan in the corporate records. Several years later, subsequent to the acquisition of the purchased entity, the corporation may have excess funds that are capable of being paid back to the original stockholders and shown as a repayment of their loans. The IRS typically steps in and reclassifies the original loans as equity under the premise that the loans are really investments in order to have the company obtain funds to purchase the other enterprise. The IRS further chimes in that the repayment of the principal would be classified as taxable income to the stockholder recipients, since the stockholders could not receive any repayment of equity unless the entire payment is classified as a dividend.

As you can see, the reclassification of a loan by a stockholder to his/her company can create a tremendous tax problem. While there is no taxable income to the company in this situation, the stockholder also cannot receive funds without taxation.
The same situation is typical when there is a lawsuit of the corporation of the individual or corporation. Without records in place, simply stated, one dollar looks the same as another dollar. Creditors are at liberty in these situations when the required records are not present.

True Loan
When an individual loans money to a privately held company and receives proper authorization from the company’s board of directors supported with legal documents, i.e. loan papers, corporate resolutions and a schedule for repayment, the law generally allows the loan to remain on the books of the company as a valid third party obligation. The financial accounting records will show a debt from the corporation to the individual. Interest will be deducted by the corporation and will be taxed to the stockholder upon receipt. Finally, when the principal of the loan is repaid, whether it be in installments or a lump sum, the corporation does not obtain any tax deduction, nor does the stockholder report any income upon a return of his/her funds.

Debt Forgiveness
An alternative to repayment of a loan occurs when the stockholder forgives the debt and does not receive any funds back from his/her company. In addition, a situation may arise where an individual realizes, subsequent to loaning money to his/her company, that the company may never have the ability to repay the funds. Many times the stockholders forgive the corporation from repaying the debt.

The tax consequences of this situation depend upon the relationship of the creditor to the company:

  1. If the creditor is a shareholder of the company, the forgiveness of the debt owed to the shareholder is reclassified as a contribution to capital. This reclassification causes the forgiveness of debt to fall under the debt to equity reclassifications rules (discussed above). The law further states that not only is the debt itself reclassified, but any interest due on the note is also reclassified. Thus the result, once again, is a tax problem for the stockholder.
  2. If the creditor is not a stockholder, then the forgiveness of the debt results in taxable income to the company. There is no reclassification as a result of the status of the creditor. Further, the creditor may be barred from taking a tax deduction, unless he/she can prove a bad debt occurred.

Recommendations
Based upon the above information, readers are cautioned that when they loan money to their corporation, the loan should be classified as a true loan. In other words, there should be proper legal documents drafted and a definite payment schedule created together with a corporate resolution. The IRS has the right to reclassify the debt if the relationship between the creditor and the company is that of a stockholder and if the loan is really an additional investment in the company with no true intention of repayment. The courts, over the years, have identified many factors to be considered in reclassification of the transaction.

Another problem arises when individuals forgive loans to other individuals.

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Meet the Author
Bart Basi, Ph.D. is an attorney, a certified public accountant, and senior advisor to the Center for Financial, Legal & Tax Planning, Inc., located in Marion, Illinois, and at www.taxplanning.com. An expert on closely held enterprises, he is a member of the American Bar Association’s Tax Committees on Closely Held Businesses and Business Planning.