Albert Ellentuck, Esq., CPA
King & Nordlinger, LLP
Business owners may find themselves short of cash while the company has ample liquid reserves. If that’s the case, it might be tempting to borrow money from the business.
Such tactics may make sense, especially if the alternatives are taking a bank loan or running a credit card balance. But proceed cautiously to avoid tax traps and other dangers...
DEFEND AGAINST DIVIDENDS
Avoid simply transferring funds from the company’s bank account to your own, making a mental note that this is a loan.
Trap: If the IRS examines your personal or business records, the transfer might be considered a dividend.
Result: The entire amount could be taxable income to you. A $50,000 “loan,” for example, could add $50,000 to your income for the year.
Moreover, dividends are not deductible for the company. If you run your business as a regular C corporation, the amount of the transfer could be subject to both personal and corporate income tax.
Strategy: Any loan between a company and an employee (especially if the employee is a shareholder) should be formalized.
The loan document should state an interest rate, repayment terms, and procedures to be followed in case of default. If you’re the borrower, adhere to the terms of the loan.
Added protection: To defend against a possible future charge that the transfer was a dividend, record the loan in your corporate minutes. Make a note to the effect that a loan is being made to a corporate executive to relieve personal financial pressures and thus facilitate performance of business-related responsibilities.
A loan will look more realistic if some interest is charged, even at a below-market rate, and if that interest is paid on schedule.
LACK OF INTEREST
As mentioned, a company-to-shareholder loan will be on safest ground if interest is charged and paid. For the best tax outcomes, such interest will be at a market rate -- it will be treated as a loan rather than a taxable gift or dividend.
However, you might prefer to pay a below-market rate of interest, or no interest at all.
Tax treatment: With few exceptions, interest in such cases will be imputed by the IRS on loans between employers and employees.
Example: Walt Smith is the 100% owner of ABC, Inc. He borrows $50,000 from the company, interest free. At the time of the transaction, the applicable federal rate (AFR) published by the IRS is 4%.
Result: Imputed interest of $2,000 (4% of $50,000) will be included in Walt’s income each year.
Walt might be able to take an offsetting $2,000 deduction... but he might not. If he uses the loan proceeds for personal purposes, other than acquisition of a residence, no interest deduction will be allowed. If he uses the money for investing, interest deductions will be allowed only if Walt has taxable investment income to offset.
Below-market loans: Instead of an interest-free loan, Walt might have agreed to pay, say, 2% interest to his company. In that case, the loan is two percentage points below the AFR and the annual imputed interest would be $1,000 (2% of the $50,000 loan amount).
Suppose that Walt uses the proceeds for personal expenses. He will owe tax on $2,000 worth of “income” from imputed interest and get no tax deduction. Even so, such a transaction might be advisable.
Reason: Assuming an effective 40% tax rate (federal, state, local), Walt would owe $800 per year in tax on the $2,000 of imputed income.
If Walt borrowed the same $50,000 from a bank, in today’s interest rate environment, he might have had to pay 8% interest, or $4,000 per year.
Even worse: Putting $50,000 worth of debt on credit cards would probably have cost much more interest.
Bottom line: Using a no-interest or low-interest loan from your company might be the best way to get your hands on needed cash.
Try to start repaying the loan as soon as possible. If no repayment has been made after several years, the transaction may start to look like a dividend, with the undesirable tax treatment described above applied retroactively.
EMPLOYING THE EXCEPTIONS
In some situations, no-interest or below-market loans between employers and employees are exempt from the imputed interest tax rules.
Exception 1: Loans that total no more than $10,000 won’t trigger imputed interest.
Exception 2: Relocation loans also may be exempt from these rules.
Example: XYZ Corp. moves its headquarters from Wyoming to Arizona. Beth Jones, the sole shareholder of XYZ, also moves to a new home in Arizona.
XYZ makes Beth an interest-free loan to help her buy her new home. No interest will be imputed.
Required: To avoid imputed interest, the loan must be secured by Beth’s new residence. The note will say that the house will be sold in order to pay off the loan, if necessary.
The relocation must involve a move of at least 50 miles. The loan must not be transferable (the company can’t sell the note to another party) and must oblige the borrower to perform future services (the borrower promises to work for the company).
In addition, the rules state that the borrower must certify to the employer that he/she expects to itemize deductions each year the loan is outstanding (see Reg. Sec. 1.7872-5T[c]).
Exception 3: In some cases, the imputed interest rules can be avoided on bridge loans that are used to buy a new home while an existing residence is on the market.
Required: All the above conditions for relocation loans must be met. In addition, the loan agreement must state that the loan will be repaid in full within 15 days after the sale of the old home.
The amount of the loan can’t be more than the borrower’s reasonable estimate of the equity in the old home. Moreover, the old home must be sold rather than converted to business or rental property.
Strategy: For a relocation or bridge loan, the borrower should open a separate bank account for handling the borrowed funds. Then the loan proceeds can be traced to the purchase of a new residence, strengthening the case for exemption from the imputed interest rules.