An Illegal Loophole or a Legitimate Loan?
Owning a C corporation can feel like a constant fight against a tidal wave of taxes. Say your business is having a successful year and profits are high. Excellent! Now the question becomes, how do you as the shareholder access that money without paying a hefty tax bill? The most straightforward way is to receive dividends, but then you will owe personal income tax on that money. Not so excellent.
Now perhaps you hear about a strategy called a “shareholder loan.” Instead of receiving dividends from your corporation, you can borrow money from the company without getting hit with a tax bill. Excellent? Press pause before you continue because this isn’t a “get money tax-free” loophole for everyone to enjoy. A shareholder loan has to function as a legitimate loan, with the same terms and conditions that would exist if your company lent money to a total stranger. Otherwise, you’ll just get hit with a tax bill, anyway—and worse consequences if the IRS determines that you are evading taxes.
To Loan…
So when might a shareholder loan actually make sense? The simple answer is if the loan is an actual loan. Not a workaround to skip out on taxes. Not a way to avoid dividends—or make up for the fact that the corporation cannot distribute dividends this year (more on that later).
Here are three questions to ask to determine if your shareholder loan is legitimate—and could also function as a tax strategy:
- Would the same loan be offered to a stranger on the same terms? This is often referred to as an “arm’s-length transaction,” meaning that the business deal should operate as if the two parties have no relationship with each other. If the corporation is providing outrageously favorable terms to the shareholder just because they’re a shareholder, the IRS will notice, and the consequences will not be friendly.
- Is there a formal, written contract in place? Also known as a “debt instrument,” a loan would typically have a binding contract containing things like the interest rate and the period of time in which the loan must be repaid. If the shareholder loan is a true loan, it should have a debt instrument.
- Does the interest rate meet IRS requirements? The IRS sets a monthly Applicable Federal Rate (AFR) that establishes how much interest should be paid on private loans, family loans, and business transactions like shareholder loans. The interest rate for your loan should be at least equal to the AFR and should be stated in your contract.
Is your loan on track to meet the requirements? Then you have the go-ahead to move onto the next step: discuss the shareholder loan option with your tax planner so they can crunch the numbers and determine if this fits into your tax plan.
…Or Not to Loan
In some cases, you might have all the right pieces in place to take out a shareholder loan, but it might not be the right move from a tax planning perspective. Here’s just one example: taxpayers might be tempted to use shareholder loans to avoid taxable dividends. Obviously, a tax-free loan is better than taxable income, right?
This is where learning to think like a tax planner comes in handy. Rather than fixating on a “avoid tax at all costs” goal, take into consideration the bigger picture. Is there an opportunity to pay low-to-no tax on this income if you receive a dividend this year? This can happen if A) the dividend is a qualified dividend (it meets certain holding requirements) and B) if you happen to be in a lower tax bracket when it comes to capital gains tax. If both are true, you might only have to pay a 15% tax rate or even 0% tax on that income.
Sometimes no workaround is needed once you take the bigger tax picture into consideration.
A Last Word of Caution
There’s one other common situation when taxpayers can be tempted to misuse shareholder loans—and that’s when the company has negative retained earnings. If the corporation has more total losses over its lifetime than total profits, the company is not allowed to distribute dividends. Then what do you do if you were banking on receiving income from your C corp this year?
A shareholder loan could still be possible if you meet the requirements, but the question is, “is it wise?” Negative retained earnings point to a financial imbalance, and you do not want to get into a pattern of withdrawing money from the company if your profits cannot keep up. Consider whether there are other tax-advantaged ways to get the money you need while working to resolve the issue of negative retained earnings.
There’s More to Tax Planning Than Meets the Eye
As you can see from the examples above, creating a tax reduction strategy is not as straightforward as some may think. Sometimes avoiding distribution dividends makes sense. Sometimes it’s better to pay out that income now to enjoy a lower tax rate. Sometimes a shareholder loan is a wise move. Sometimes inadequate planning can get that loan flagged by the IRS.
How do you determine if a certain tax strategy will work for you? Put your tax planning needs in the hands of an expert. The American Institute of Certified Tax Planners trains our tax planners to look at the bigger picture and use creative problem-solving to customize a tax plan that works for you. Get started today. Reach out to a Certified Tax Planner!
