If you’re a business owner considering lending money to a shareholder, it’s important to be aware of the rules governing applicable federal rates (AFRs). The IRS publishes monthly AFRs that determine the minimum interest rate you must charge on loans to shareholders in order to avoid complicated below-market interest rules. Failure to comply with these rules can result in additional taxes and penalties.
For loans of $10,000 or less, you may make de minimis loans without charging interest. But if loans from the business to a shareholder exceed $10,000, you’ll need to charge an “adequate” rate of interest to avoid the below-market interest rules.
Calculating the correct AFR for a demand loan, which is payable whenever the company wants to collect it, is more challenging than a term loan. The interest rate for a demand loan varies based on market conditions, making it difficult to fix the interest rate when setting up the loan. As a result, administering a shareholder loan with a prescribed term is generally simpler than a demand note.
If your company lends money to an owner at an interest rate that’s below the AFR, the IRS requires it to impute interest under the below-market interest rules. Calculating the imputed interest on a below-market loan can be complicated, as it depends on several factors such as the loan’s setup date and whether it’s a demand or term loan.
Moreover, the IRS may reclassify the loan as either a dividend or additional compensation, which can have tax implications for both the company and the shareholder. While the company can deduct additional compensation, it will also be subject to payroll taxes. Dividends and additional compensation are taxable income for the shareholder.
To avoid these issues, it’s crucial to understand the IRS below-market interest rules and ensure you comply with them.
Bona fide loans
When the IRS assesses whether payments made to shareholders can be classified as bona fide loans, it takes into account a variety of factors. These include:
- The size of the loan,
- The company’s earnings and dividend-paying history,
- Provisions in the shareholders’ agreement about limits on amounts that can be advanced to owners,
- Loan repayment history,
- The shareholder’s ability to repay the loan, based on his or her annual compensation, and
- The shareholder’s level of control over the company’s decision making.
In addition to these criteria, the IRS also considers whether the loan agreement has been formally documented in a written note that details all the repayment terms. It is crucial that the loan contract outlines critical aspects, including the interest rate, maturity date, any collateral used to secure the loan, and a repayment schedule.
By ensuring that all these requirements are met, you can help establish that the loan to shareholders is bona fide and legitimate, potentially avoiding tax penalties and legal issues.
A shareholder loan could be a smart tax planning move to make when the rates are low. Similar to family loans, this is not something to take casually. Given the complexity of the IRS rules, it’s always best to consult with your tax advisor before making a loan. Additionally, it’s important to keep accurate records of all transactions related to shareholder loans, including loan agreements, repayment schedules, and interest payments, to demonstrate that the loans are bona fide and comply with all applicable regulations.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.