If you own a closely held corporation, you have the option to borrow funds from your business at rates that are lower than those charged by a bank or other commercial lender.
There are some key benefits and risks associated with borrowing funds from your corporation that should be considered before doing so.
Basics of this strategy:
Interest rates on the open market have steadily increased over the last couple years. As a result, shareholders of closely held corporations have turned to their businesses for personal loans in lieu of taking out loans from banks or other commercial lenders. In general, the IRS expects closely held corporations to charge interest on related-party loans, including loans to shareholders, at rates that at least equal applicable federal rates (AFRs). Loans given at rates under the AFRs can trigger adverse tax consequences. Fortunately, AFRs are lower than the rates charged by commercial lenders.
It can be advantageous to borrow money from your closely held corporation to pay for personal expenses. These expenses may include, but are not limited to, your child’s college tuition, home improvements, a new car, or high-interest credit card debt. However, there are two key areas of risk that should be considered before utilizing this strategy:
- Legitimacy of the Loan. When borrowing money from your corporation, it is important to establish a bona fide borrower-lender relationship. If this type of relationship is not established, the IRS could potentially reclassify these loan proceeds as additional compensation to you. The result of this would be a large increase to your personal income tax, as well as a payroll tax liability for both you and your corporation. These additional taxes outweigh any resulting payroll and payroll tax deductions that the business would be able to incur.
In addition, if your company is structured as a C corporation, the IRS could take the stance that you received a taxable dividend if a bona fide borrower-lender relationship is not established. This would trigger taxable income for you with no offsetting deduction for your business.
The best practice to establish a bona fide borrower-lender relationship is to create a formal written loan agreement that establishes your unconditional promise to repay the corporation a fixed amount under an installment repayment schedule or on demand by the corporation. Other steps such as documenting the terms of the loan in your corporate minutes and consulting your business’s legal counsel are also good strategies to establish this relationship and ensure the legitimacy of the loan.
- Charging adequate interest. Another risk to consider before taking out a loan from your business is the minimum interest rate to charge on the loan. Lending funds under this minimum interest rate could trigger complicated and generally unfavorable “below-market loan rules” to both you and your business. The minimum rate established for these loans is the IRS-approved AFRs. Note that there is an exception to the below-market loan rules if the aggregate loans from a corporation to a shareholder are $10,000 or less.
Current AFRs:
The IRS publishes AFRs monthly based on market conditions. For loans made in July 2024, the AFRs are:
- 4.95% for short-term loans of up to three years,
- 4.40% for mid-term loans of more than three years but not more than nine years, and
- 4.52% for long-term loans of over nine years.
These annual rates assume monthly compounding of interest. The AFR that applies to a loan depends on the structure of the loan (demand or term loan). This distinction is important. A demand loan is payable in full at any time upon notice and demand by the corporation, while a term loan is any borrowing arrangement that isn’t a demand loan. The AFR for a term loan depends on the term of the loan, and the same rate applies for the entire term.
An example:
Suppose you borrow $100,000 from your corporation with the principal to be repaid in installments over 10 years. This is a term loan of over nine years, so the AFR in July would be 4.52% compounded monthly for 10 years. The corporation must report the loan interest as taxable income.
On the other hand, if the loan document gives your corporation the right to demand full repayment at any time, it’s a demand loan. Then, the AFR is based on a blended average of monthly short-term AFRs for the year. If rates go up, you must pay more interest to stay clear of the below-market loan rules. If rates go down, you’ll pay a lower interest rate.
Term loans for more than nine years are generally more beneficial from a tax perspective than short-term or demand loans because they lock in current AFRs. If rates drop, a high-rate term loan can be repaid early, and your corporation can enter into a new loan agreement at the lower rate.
Other adverse consequences to consider:
Shareholder loans can be complicated and there are other adverse consequences to consider when dealing with them. Some complexities that could lead to these adverse consequences are: if the loan charges interest below the AFR, the shareholder stops making payments on the loan, or the corporation has more than one shareholder. Our tax professionals at Wegner CPAs are experienced with the difficulties of navigating these loans. Contact us about how to proceed in your situation.
