It’s typical for business owners to seek to get capital out of their businesses with as little tax effect as possible.
In the context of an S corporation, this often looks like a shareholder-employee trying to set their salary as low as possible but still ensuring that it is considered “reasonable.”
But it can also look like a shareholder-employee of an S corporation getting a bit more creative with their tax strategy and asking whether they canborrowmoney from their S corporation.
I admire the creative thinking here — after all, apart from the interest paid on them, loans don’t create a taxable event…do they?
Book a Free Call: I’m a CPA with “Big 4” tax experience. If you’re interested in working with my firm on your S corporation tax matters, email me at [emailprotected].
Can an S Corporation Make a Loan to a Shareholder?
Yes, an S corporation can make a loan to a shareholder.
However, there are pitfalls that you should consider before putting together such an arrangement.
Documenting the Loan
It’s absolutely essential that you establish a formalized lending agreement between your S corporation and you. This agreement should include:
The interest rate of the loan, which must absolutelynot be below the applicable federal rate
When the loan will be repaid
A consequence for failure to repay the loan
Essentially, the loan should be documented, just like a loan between your S corporation and an unrelated third party would be documented.
If your loan isnot documented just like any other loan would be, it could cause the IRS to determine that your “loan” is not a loan at all but rather disguised compensation.
Although collateral for the loan is not technically a requirement, a loan being collateralized is generally a helpful factor to indicate that a transfer of funds is, in fact, a loan rather than something else like a gift, a distribution, or shareholder compensation.
Repaying the Loan
Of course, it’s not enough to merely dot your i’s and cross your t’s with the loan agreement; you must also repay your loan according to schedule.
If you do not, the IRS could recharacterize the “loan.”
If this loan was to a third party, would your S corporation be so lenient as to let that third party borrower miss payments, even once in a while?
Of course not.
So the same should be true for your repayment of the loan from your S corporation — lenience on the part of your S corporation toward your failure to repay the loan in a timely manner would indicate to the IRS that this transfer of money was not a loan at all but something else.
Loan vs. Distribution
If the loan from your S corporation to you is not properly structured and documented, the IRS could reclassify the transfer of funds as a distribution.
You may be wondering what’s so bad about that since distributions out of an S corporation are generally tax-free since shareholders pay tax on their S corporation income based not on when they received cash out of their S corporation but on the S corporation’s taxable income during the year.
Althoughusually S corporation distributions do not have negative tax ramifications, they certainly could.
For example, if a shareholder does not have enough basis in the S corporation, any distributions they receive in excess of their basis would constitute taxable income.
Also, if only one shareholder out of several receives a “loan” from an S corporation and the IRS recharacterizes this “loan” as a distribution, this could cause that shareholder’s distributions for the year to exceed their S corporation ownership percentage.
This could have catastrophic tax consequences since this could indicate that the S corporation has two classes of stock, which would lead to an involuntary termination of the business’s S corporation election.
The IRS recharacterized loans made to Greenlee from Greenlee’s S corporation as wages, and the United States District Court of Colorado agreed because:
The loans were unsecured (i.e. they were not collateralized) and bore no interest.
Greenlee merely took out the loans as he saw fit; there was no documentation of when these loans would be taken out.
Greenlee performed services for the S corporation. Note that this is just one factor of money; obviously many S corporation shareholders perform services for their S corporation, and this fact alone does not indicate that a loan from the S corporation to them should be recharacterized.
There were no actual repayments of the loan beyond accounting entries.
Although this case is merely a district court case, the IRS is certainly aware of this case and may use it in investigation purported loans made by S corporations to their shareholders.
S Corporation Loans to Shareholders: Conclusions
Here’s a summary of what you need to know about S corporations lending money to their shareholders.
S corporations may loan money to their shareholders, but these arrangements should be taken with caution since the IRS could recharacterize these transactions as wages, distributions, or something else.
It is essential for the loan between the S corporation and the shareholder to have all the markings of a loan that would be made to a third party such as a market interest rate, a repayment schedule, late payment fees, and consequences for failure to pay back the loan (such as the seizing of collateral).
If the shareholder does not pay back the loan as stated in the loan agreement, it is important for the S corporation to treat the shareholder just as it would an unrelated third party. The S corporation’s failure to do this would be a major factor in favor of recharacterization.
The IRS’s recharacterization of an S corporation “loan” to a shareholder as something else could have significant negative tax implications for the S corporation, the shareholder(s) “lent” money, and the other shareholders as well.
Book a Free Call: I’m a CPA with “Big 4” tax experience. If you’re interested in working with my firm on your S corporation tax matters, email me at [emailprotected].
When you're taking money out of an S Corp other than your salary, you can set up a line of credit between you and your business. Then, you'll take cash out as a loan against that line of credit.
In the case of an S corp, the shareholder usually borrows money and then lends it to his S corp. The shareholder is personally liable for the debt and there is bona fide indebtedness from the S corp to the shareholder so debt basis is allowed.
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.
It's up to you to determine how often to pay yourself an employee salary. It might be once or twice a month, once a week, every other week or less often. If you ever need more money, you can take a shareholder distribution at any time.
The 60/40 rule describes where owners pay 60% of their salary and the remaining 40% as a distribution. For example, if an S Corp owner earns $50,000 annually, they'd pay themselves a $30,000 salary and a $20,000 profit distribution.
Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits. In technical lingo, an S corporation is not permitted to have any retained earnings.
Many small businesses need help with financing, particularly when they're starting out, and entrepreneurs and small business owners often use their own money to found a business or help keep their businesses afloat. Under most state laws, it is legal to lend money to your own LLC.
The main benefit of incorporating as an S corporation over being self-employed is the tax savings on self-employment taxes (Social Security and Medicare). For each dollar of profit, it could mean as much as 14.13% in savings when it's time to pay taxes.
Instead, S corp owners can draw money from the business by using shareholder distributions. A shareholder distribution is a payment from the S corp's earnings taxed at the shareholder level. In other words, shareholder distributions are not recorded as personal income or subject to Social Security or Medicare taxes.
The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
The two ways to take earnings out of an S corporation are either as earned wages required when corporate officers perform services for the company or as shareholder distributions. Profits are attributed to shareholders at the same percentage as each shareholder's percentage of ownership interest.
To open an S corporation bank account, you must first obtain an Employer Identification Number (EIN). You may need two bank accounts, one for regular business transactions and another one for depositing the withheld taxes.
What is a Debt Basis? Measuring a shareholder's debt basis is similar to measuring a stock basis. To calculate a debt basis, you take the original amount the stockholder loaned to the corporation and increase his or her basis for that loan and any additional loans he or she provided.
If, after the 2-year period, the trust continues to hold S corporation stock and does not otherwise qualify as a permitted shareholder, the corporation's S election terminates. If the termination is inadvertent, the corporation may request relief under section 1362(f).
Once a valid S corporation election is terminated or revoked, the corporation or any successor corporation is generally prohibited from making a new election for five years. The five-year period begins with the tax year after the first tax year for which a termination or revocation is effective (IRC § 1362(g) ).
If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. Debt basis is not considered when determining the taxability of a distribution.
It's also worth remembering that every time an owner takes a draw, it reduces the company's equity, and therefore fewer funds are available for future purchases. The salary method is more predictable and better for tax purposes since you know exactly when your paycheck will hit your account and what the amount will be.
By paying reasonable salaries to its shareholders as required, the S-corp can avoid having their tax-favored distributions questioned by the IRS and reclassified as salaries. And while those salaries are subject to employment tax, those taxes are deductible by the S-corp.
What is a 2% shareholder? According to the IRS, a 2% S corporation shareholder is someone who owns more than 2% of the company's stock at any time during the year. This also applies to individuals who own more than 2% of the company's voting power. S Corp shareholders include individuals, trusts, or estates.
Both C and S Corps follow the same guidelines for filing taxes with no income. If you had no income, you must file the corporation income tax return, regardless of whether you had expenses or not. The bottom line is: No income, no expenses = Filing Form 1120 / 1120-S is necessary.
Taxes on S corporations are lower than on non-S corp.LLCs. As an LLC owner, you'll incur steep self employment taxes on all net earnings from your business, whereas an S corporation classification would allow you to only pay those taxes on the salary you take from your company.
Retirement loans allow you to borrow money from yourself. And unlike a withdrawal from your 401(k), you don't have to pay taxes and penalties on a loan. They also offer some of the lowest rates available, even if your credit score is low.
One of the most common ways to fund your LLC is with personal funds. This can include your savings, retirement accounts, and personal loans. While this option may not be ideal for everyone, it's a good way to get started if you don't have a lot of capital.
From a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp. In general, with around $40,000 net income you should consider converting to S-Corp.
The Best Tax Deductions for S-Corporations: State & Local Taxes, Fees & Advice. Your local and state income taxes, excise taxes, sales taxes, and incurred use taxes can typically qualify as business expenses, which makes them tax deductible.
The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level.
The business profit is evenly divided (50/50) between owner salary and profit distribution. For example, if an S Corp owner makes $100,000 annually, the W2 salary would be $50,000 and the profit distribution would be $50,000. This article will examine the S-Corp salary 50-50 rule and discuss a few myths.
Shareholders, or owners, of C corporations, can take money out of the company in two ways: salary and wages or dividends. These corporations pay income taxes on all profit, including profit distributed to shareholders.
So, what's the tax benefit of an S Corp? The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.
A: Distributions do not need to be taken on a regular basis, they can be irregular, and the amounts can vary. The important thing is that by the end of the year they not represent more than (using the rule of thumb) 40% of your total monies received by the corporation.
S corporations, in general, do not make dividend distributions. They do make tax-free non-dividend distributions unless the distribution exceeds the shareholder's stock basis. If this happens, the excess amount of the distribution is taxable as a long-term capital gain.
If you plan to deposit a large amount of cash, it may need to be reported to the government. Banks must report cash deposits totaling more than $10,000. Business owners are also responsible for reporting large cash payments of more than $10,000 to the IRS.
An S corporation is able to hire employees, but employees are not a requirement. S corporations get taxed the same as partnerships and sole proprietorships. All three of these entities enjoy pass-through taxation. All profits of an S corporation get taxed on shareholders' annual individual returns.
Business owners may qualify to claim the home office deduction if they have their own business and use a portion of their home as their principle place of business. The S corporation can pay you rent for the home office.
When you're taking money out of an S Corp other than your salary, you can set up a line of credit between you and your business. Then, you'll take cash out as a loan against that line of credit.
Cash contributions are probably the easiest way for an S corporation shareholder to make their capital contribution; with a cash contribution, the shareholder hands over a check, and the amount is entered into that shareholder's capital account. Capital contributions can also be made with property or services.
Companies raise debt capital by borrowing from lenders and by issuing corporate debt in the form of bonds. Equity capital, which comes from external investors, costs nothing but has no tax benefits.
An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities.
Sole proprietorships write off bad debts on line 27a of Schedule C, Profit or Loss From Business. Partnerships use line 12 of Form 1065, U.S. Return of Partnership Income. Bad debt deductions for S corporations go on line 10 of Form 1120-S, U.S. Income Tax Return for an S Corporation.
When shareholders are allocated losses from an S Corporation they can use the losses to offset income from other sources — if the losses pass three tests, the first two of which, “stock basis” and “at-risk” limitation rules, are the subject of this article. Both are based on how the loss was funded.
Many small businesses need help with financing, particularly when they're starting out, and entrepreneurs and small business owners often use their own money to found a business or help keep their businesses afloat. Under most state laws, it is legal to lend money to your own LLC.
Loans aren't taxable, but compensation is and distributions may be taxable. 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).
Yes. The only hitch is that you'll need to have the proper paperwork drafted to acknowledge what the business owes you and how it will repay the loan. In addition, your LLC will need to make regular payments, and you'll have to charge at least a nominal interest rate to make the transaction legal.
What is the 60/40 rule? The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
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Introduction: My name is Cheryll Lueilwitz, I am a sparkling, clean, super, lucky, joyous, outstanding, lucky person who loves writing and wants to share my knowledge and understanding with you.
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