This is obviously an important issue as we look at our small S corporation shareholders and how they finance their businesses. I know I have a number of clients who I have to remind of this every year. Thanks again to the EAJournal and its Q & A.
Q. My client loaned money to his business (an S corporation). What are the restrictions, if any, for a 100 percent S corporation shareholder loaning money to his corporation for a stated interest rate? Are there limitations when he is the only shareholder? Does the IRS restrict this activity in any way? Does the IRS classify this as paid-in-capital only?
A. The issue of whether funds transferred from a shareholder to an S corporation is a loan or a contribution of capital is an area that can be subject to close IRS scrutiny. The IRS has the authority to reclassify a transaction as a capital contribution under certain circumstances. There are several key elements used to determine whether a shareholder’s transfer to a corporation is a loan or a capital contribution. For example, some of these factors are whether:
- There is a written, legally enforceable agreement between the corporation and the shareholder;
- The loan is set at a market rate of interest, and interest payments are made on a regular basis (or in accordance with the terms of the loan);
- The corporation could have obtained a loan from a third-party (instead of the shareholder);
- The debt is collateralized; and/or
- The corporation is sufficiently capitalized without the shareholder’s loan.
The effect of whether a transfer of funds to a wholly owned corporation is classified as debt or equity affects the shareholder’s debt or stock basis. This in turn affects the shareholder’s ability to claim losses and any gains or losses from the sale or disposition of the company.