This article will provide a brief overview of what a shareholder loan is, and the difference between equity and debt as two types of loans. Next, the tax consequences to corporations of shareholders’ interest on loans will be discussed. The last section will mention a few of the impacts that shareholder loans can have on target and acquiring companies as they undergo the process of a merger or acquisition.
What is a shareholder loan?
Ashareholder loan includes any funds that a shareholder has contributed to thecorporation or any funds that are lent from the corporation to the shareholder.Here are a few examples of types of shareholder loans that are common incorporations:
- A business loans cash to a shareholder for a personal expense
- A shareholder contributes cash directly to the business
- A shareholder pays for a business expense with personal funds
Equity Investment vs. Debt
Some owners of small corporationsfund operations out of their own pockets. These payments can be treated asequity or debt in the company’s account books. A cash infusion can beclassified as equity if the shareholder receives an ownership percentage in theform of stock in return, and thereby is not a loan. When the shareholder sellstheir equity, they will receive all or only a portion of their investment back.
A debt is a loan of money from the shareholder to the business. This loan should be authorized by the board of directors, and must be paid back according to the terms agreed upon by the board of directors.
Interest on Loans
Shareholderscan receive earnings as a dividend or as interest on loans made to thecorporation. The corporation is not usually allowed a deduction on dividendspaid, so dividends do not constitute loans. The corporation is allowed adeduction on interest on a shareholder loan, although the deduction is subjectto a few limitations:
- The loan has to be treated as debt rather than equity for US federal income tax purposes.
- Principal repayments are not considered to be taxable income to the lender.
- For a foreign shareholder, debt financing may be beneficial from a US withholding tax perspective: repayment of the loan principal is typically not subject to a US withholding tax, and withholding tax on interest may be reduced below 30% on an appreciable treaty. See Withholding Taxes for a more general discussion.
Ownership Transfers & Negotiated Terms of Sale
One way to sell a corporation is by transferring 100% of the company’s stock to new shareholders, as is described in Asset Sales vs. Stock Sales. In this case, all debts, including those owed to prior shareholders, remain in effect. The acquiring corporation is liable for any defaults on loans to prior shareholders.
Acquiring companies should keep inmind that shareholders of small businesses may be reluctant to walk away fromtheir business, since they will have no control over how their loans arerepaid. One answer to this sometimes-thorny question is that the procedure forrepayment may depend on the terms of the shareholder loan. Sometimes, the termswill stipulate that the company pays back the loan in full before the sale orfrom the proceeds of the sale. Both target companies and acquiring companiesshould be aware that an alternative exists: repayment of loans can benegotiated during the process of selling the company.
These are important negotiations, since the target company’s liabilities, including loans, must be settled by compensating owners with cash, shares, or share options in the newly combined entity. A target company should be careful to limit liabilities, since this can hinder negotiations or cause the target to lose leverage if the company requires restructuring. An acquiring company can approach this situation by choosing to acquire assets selectively. The acquiring company has a position of bargaining power, and can cherry-pick the assets it perceives to be the most valuable while sidestepping liabilities such as loans.
Conclusion: Key Takeaways
We discussed the different typesof shareholder loans, and the difference between equity and debt. Whether a cashinfusion is classified as debt or equity determines whether it is treated as aloan. Interest can be deducted for U.S.federal tax purposes, whereas dividends cannot receive the same treatment.
Also, loans often impact acorporation’s negotiating power regardless of their side of the deal. Morespecifically, too many liabilities can damage a target company’s negotiations,or provide an advantage to the acquiring company. Too many loans can alsonegatively impact an acquiring company if they fail to do their due diligence,or negotiate poorly, since they are ultimately liable for all loans.
