Can I Borrow Money From My S Corporation?

An S corporation’s structure allows its owners, known as shareholders, to borrow funds from the business. This arrangement can provide a convenient source of capital for a shareholder. However, the transaction must be meticulously structured as a formal loan to be recognized as legitimate by the Internal Revenue Service (IRS). An improperly handled loan can be reclassified by the tax authorities, leading to significant and unfavorable tax outcomes for both the shareholder and the corporation. The key is to treat the transaction with the same seriousness and formality as a loan from an unrelated commercial lender.

Establishing a Bona Fide Shareholder Loan

For the IRS to recognize a transfer of funds from an S corporation to a shareholder as a loan, it must be a “bona fide” debt. This means there must be a genuine intention for the money to be repaid. Several factors are examined to determine this intent, creating a clear distinction between a legitimate loan and a disguised salary or distribution of profits. The presence of a formal, written agreement is a primary indicator, serving as tangible evidence of the debt’s existence and terms.

An element of a bona fide loan is a reasonable interest rate. The rate charged must be at least the Applicable Federal Rate (AFR), which is a set of minimum interest rates published monthly by the IRS. Using a rate below the AFR can trigger complex tax rules for below-market loans, potentially resulting in imputed interest income for the corporation and the shareholder. The loan must also have a fixed repayment schedule, outlining specific dates and amounts for principal and interest payments, demonstrating a clear expectation of repayment.

To further solidify the loan’s legitimacy, securing it with collateral, such as personal assets of the shareholder, is a strong indicator of a true debtor-creditor relationship. While not always mandatory, collateral shows that the corporation has a means of recourse if the borrower defaults, similar to a traditional bank loan. The shareholder must adhere to the repayment schedule and make actual, timely payments. A history of consistent repayments provides powerful evidence that both parties are treating the arrangement as a serious financial obligation.

Required Documentation and Corporate Formalities

The foundation of a defensible shareholder loan is proper documentation, which begins with a comprehensive promissory note. This legally binding document is the primary evidence of the debt and must contain specific details to be valid, including:

• The lender (the S corporation) and the borrower (the shareholder)
• The exact principal amount of the loan
• A stated interest rate that meets or exceeds the AFR
• The repayment terms, including the frequency and amount of payments
• The final maturity date

Beyond the promissory note, proper corporate governance requires a formal resolution from the board of directors authorizing the loan. This resolution should be recorded in the official corporate minutes and serves as proof that the corporation’s leadership formally approved the transaction. This step demonstrates that the loan was made with the corporation’s best interests in mind and was not an arbitrary decision.

Tax Consequences of an Improper Loan

If a shareholder loan is not properly structured, documented, and managed, the IRS can disregard its classification and recharacterize the funds in one of two ways, each with distinct tax consequences. The first and more common reclassification is treating the loan as a distribution of company profits. In this scenario, the tax impact on the shareholder depends on their stock basis, which is essentially their investment in the company. The distribution is tax-free only up to the amount of the shareholder’s stock basis.

Any portion of the distribution that exceeds the shareholder’s stock basis is taxed as a long-term capital gain, assuming the stock has been held for more than one year. For the S corporation, a reclassified distribution does not generate a tax deduction, unlike the interest income it would have earned on a legitimate loan.

A more financially burdensome outcome is the reclassification of the loan as compensation or salary to the shareholder-employee. This typically occurs when the shareholder provides services to the corporation and the loan appears to be a substitute for reasonable wages. If the IRS deems the transaction to be disguised compensation, the entire amount becomes subject to FICA taxes, which include Social Security and Medicare taxes. These taxes are imposed on both the employee-shareholder and the S corporation, creating a significant and immediate cash expense for both parties.

Accounting for the Loan and Repayments

The initial loan amount is recorded on the corporation’s balance sheet as an asset, typically under an account titled “Loan to Shareholder” or “Note Receivable from Shareholder.” This entry reflects that the corporation is owed money and expects to receive future economic benefit from the repayment of the debt.

As the shareholder makes payments according to the promissory note’s schedule, each payment must be carefully allocated. A portion of the payment represents interest, and the remainder is a repayment of the principal. The principal portion of the payment reduces the outstanding balance of the “Loan to Shareholder” asset account on the balance sheet. The interest portion is recorded as “Interest Income” on the corporation’s income statement. This interest income increases the corporation’s profits and subsequently flows through to the shareholders on their individual Schedule K-1 forms, where it is reported as taxable income.