Strategy Basics
With the recent increase in interest rates, shareholders might prefer borrowing from their corporations instead of paying higher bank loan rates. Generally, the IRS expects closely held corporations to charge interest on related-party loans, including loans to shareholders, at least equal to the applicable federal rates (AFRs). Failure to comply with this can lead to adverse tax consequences. Fortunately, AFRs are typically lower than commercial lending rates.
Borrowing from your closely held corporation can be beneficial for covering personal expenses, such as college tuition, home improvements, a new car, or high-interest credit card debt. However, you must avoid two key risks:
Key Risks
- Not Establishing a Legitimate Loan: Establishing a bona fide borrower-lender relationship is crucial. If not, the IRS might reclassify the loan proceeds as additional compensation, resulting in an income tax bill for you and payroll tax liabilities for both you and your corporation. The business would be allowed to deduct the amount treated as compensation and the corporation’s share of related payroll taxes.
Alternatively, if your company is a C corporation, the IRS might treat the loan as a taxable dividend, leading to taxable income for you without an offsetting deduction for your business.
To avoid these issues, draft a formal written loan agreement that establishes your unconditional promise to repay a fixed amount under an installment repayment schedule or on demand by the corporation. Document the loan terms in your corporate minutes as well.
- Not Charging Adequate Interest: To avoid the unfavorable “below-market loan rules,” your business must charge at least the IRS-approved AFR. (An exception exists if the aggregate loans from the 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 applicable AFR depends on whether the loan is a demand or term loan. A demand loan is payable in full at any time upon notice and demand by the corporation, while a term loan has a fixed repayment schedule. The AFR for a term loan applies for its entire duration.
Example
Suppose you borrow $100,000 from your corporation, with the principal to be repaid in installments over 10 years. This term loan, being over nine years, would have an AFR of 4.52% compounded monthly for 10 years. The corporation must report the loan interest as taxable income.
Conversely, if the loan agreement allows the corporation to demand full repayment at any time, it is a demand loan. The AFR is then based on a blended average of monthly short-term AFRs for the year. If interest rates rise, you must pay more interest to comply with the below-market loan rules. If rates fall, you pay a lower interest rate.
Long-term loans of more than nine years are generally more tax-efficient than short-term or demand loans as they lock in current AFRs. If interest rates drop, a high-rate term loan can be repaid early, and a new loan agreement can be made at a lower rate.
Avoid Adverse Consequences
Shareholder loans can be complex, particularly if the interest charged is below the AFR, the shareholder ceases payments, or the corporation has multiple shareholders. Contact us for professional guidance tailored to your situation.
