Don’t Lose Your Company’s S Corporation Status

By Karl Heafield August 7, 2014

(Loans Treated as Disproportionate Distributions)

Can loans between an S corporation and its shareholders lead to a termination of the corporation’s S election? In some instances, yes! When such loans exist, there are several potential pitfalls that business owners should be aware of and avoid.

Loans treated as disproportionate distributions

In order for a corporation to maintain S corporation status, it generally may not have more than one class of stock. Exceptions exist that allow different voting rights, but classes that provide different distribution rights are prohibited. That means distributions to shareholders must be paid in proportion to each shareholder’s ownership interest.

Sometimes loans are viewed as disguised distributions. If shareholder loans are present and they are not respected as true loans, the following risks are present:

1. If the S corporation loans funds to a shareholder the loan could be re-characterized as a distribution, thereby causing distributions to be disproportionate.
2. If a shareholder has previously loaned funds to an S corporation and such loan is re-characterized as an equity investment, payments by the corporation to the shareholder could also be re-characterized as distributions again causing such distributions to be disproportionate.

IRS audit activity has increased for S corporations with respect to loans between corporations and their shareholders. If during an audit the IRS determines that the loan is not bona fide, any cash transferred to a shareholder with respect to the loan can be re-characterized as a distribution. This re-characterization means the S corporation will have made disproportionate distributions to its shareholders, which could lead to a termination of the corporation’s S election, exposing the corporation and its shareholders to double-taxation.

Solutions

With proper planning and documentation, there are ways corporations can avoid these potential pitfalls, even in the presence of shareholder loans, which are perfectly acceptable and often serve as valid and beneficial tax planning tools. To avoid pitfalls, the corporation should follow these steps when making a loan to a shareholder:

1. Make sure the loan is in writing. An attorney-drafted loan document is the most acceptable form of documentation.
2. Make sure the loan’s terms are fair and reasonable. They should be terms that would be acceptable to two unrelated parties.
3. Make sure the loan does not violate any bank covenants.
4. Make sure the loan has an adequately stated interest rate. The IRS has prescribed acceptable interest rates that can be used for this purpose: The Applicable Federal Rates (“AFR”), which are updated and published by the IRS on a monthly basis. The lender must report the interest income on its tax return, and the borrower must report the corresponding interest expense on its tax return.
5. Lastly, and most importantly, make sure that the terms of the loan are being adhered to (i.e. principal and interest payments are being made as scheduled in the loan documents).

By following these steps, S corporations and shareholders can avoid the unfortunate consequences of having a loan re-characterized by the IRS as a distribution.

If you would like to discuss further, please call Karl Heafield or your BNN tax advisor at 1-800-244-7444.