Loan to Shareholder vs. Distribution: Tax & Legal Risks

When a shareholder in a closely-held corporation needs cash from the business, they face a choice: structure the transaction as a loan or a distribution. The Internal Revenue Service (IRS) closely scrutinizes these arrangements, and the path chosen carries significant tax and legal consequences. An improperly structured loan can be reclassified as a taxable distribution, creating unexpected liabilities for both the shareholder and the corporation. The distinction hinges on intent, documentation, and adherence to corporate formalities, which collectively determine the economic reality of the transaction.

Establishing a Bona Fide Shareholder Loan

For the IRS to recognize a payment to a shareholder as a loan, it must be a “bona fide” debt, meaning there is a genuine intention for the funds to be repaid. The primary evidence is a formal, written promissory note executed at the time of the loan. This legal instrument should clearly state the loan amount, the interest rate, a fixed repayment schedule, and the maturity date.

A commercially reasonable interest rate is another factor. The rate should be comparable to what an unrelated third-party lender would charge, and the IRS publishes Applicable Federal Rates (AFRs) monthly that serve as a baseline. Charging a below-market rate can result in the IRS imputing interest, creating taxable income for the corporation and potentially for the shareholder.

The actions of both parties must align with the existence of a loan. The corporation should record the transaction as a note receivable on its balance sheet, and the shareholder should reflect it as a liability. Consistent repayments by the shareholder according to the promissory note are powerful evidence of a loan’s legitimacy. The shareholder’s ability to repay the loan at the time it is made is also considered; if there is no realistic prospect of repayment, the transaction may be viewed as a disguised distribution. Securing the loan with collateral can further solidify its status as a bona fide debt.

The Nature of Shareholder Distributions

A shareholder distribution is a payment made by a corporation to its owners with respect to their stock with no expectation of repayment. The tax treatment of a distribution is different from that of a loan and depends on the corporation’s tax structure—specifically, whether it is a C-Corporation or an S-Corporation.

C-Corporation Distributions

For a C-Corporation, distributions are treated as dividends to the extent of the corporation’s current or accumulated “earnings and profits” (E&P), a tax measure of a company’s ability to pay dividends. If a distribution is paid from E&P, it is taxable income to the shareholder. This creates “double taxation,” where the corporation pays income tax on its profits, and shareholders pay personal income tax on those same profits when distributed as dividends.

Distributions that exceed the corporation’s E&P are treated differently. The excess amount is first considered a non-taxable return of capital, which reduces the shareholder’s stock basis. Once the shareholder’s stock basis is reduced to zero, any further distributions are taxed as a capital gain. The corporation reports dividend payments to shareholders on Form 1099-DIV.

S-Corporation Distributions

S-Corporations are pass-through entities, meaning their income and losses are passed directly to the shareholders, generally avoiding double taxation. The taxation of distributions from an S-Corporation follows a three-tiered system tied to the shareholder’s stock basis, which each shareholder is responsible for tracking.

First, distributions are tax-free up to the amount of the shareholder’s stock basis and are treated as a return of investment. This distribution reduces the shareholder’s basis but is not included in their taxable income. Shareholders must track their basis annually, adjusting it for their share of corporate income, losses, and prior distributions.

If a distribution exceeds the shareholder’s stock basis, the excess amount is taxed as a capital gain. A third tier of taxation can apply if the S-Corporation was previously a C-Corporation and still has accumulated E&P. In such cases, distributions made after the shareholder’s basis is depleted may be taxed as dividends to the extent of that old E&P.

Consequences of Loan Reclassification

The primary risk of an improperly structured shareholder loan is that the IRS will reclassify it based on its economic substance. If the IRS determines there was no genuine intent for repayment, it will treat the payment as either a taxable distribution or additional compensation.

The most common outcome is reclassification as a distribution, often called a “constructive dividend.” For the shareholder, the entire principal amount becomes taxable income in the year it was received, which can result in a substantial tax bill plus penalties and interest. The corporation also loses any deduction for payments it received as “interest.” Any money the shareholder pays back is not a loan repayment but a new capital contribution, which increases the shareholder’s stock basis but provides no tax benefit to the corporation.

Alternatively, if the shareholder is also an employee, the IRS may reclassify the loan as salary or compensation. In this scenario, the amount is subject to payroll taxes for both the shareholder-employee and the corporation. However, the corporation can generally deduct the amount as a compensation expense, which can offset the negative tax impact at the corporate level.

Documentation and Corporate Formalities

Proper documentation and adherence to corporate formalities are necessary to defend the tax treatment of any transaction between a corporation and its shareholders. These actions provide objective evidence of the board’s intent and the transaction’s substance.

For a Shareholder Loan

To substantiate a shareholder loan, the process must begin with formal approval by the corporation’s Board of Directors. This approval should be recorded in the corporate meeting minutes, which serve as a legal record of the board’s decisions. The minutes should state the board’s resolution to grant a loan and specify its terms.

For a Shareholder Distribution

Shareholder distributions also require formal action by the Board of Directors. The board must declare its intention to issue a distribution, and this declaration, including the amount per share and the payment date, must be documented in the minutes of the board meeting. This formality ensures the action is a deliberate corporate decision. The corporation’s financial records must also accurately reflect the payment as a distribution, which reduces the company’s retained earnings.