June 15, 2017
It’s common for closely held businesses to transfer money into and out of the company, often in the form of a loan. However, the IRS looks closely at such transactions: Are they truly loans, or actually compensation, distributions or contributions to equity?
Loans to owners
When an owner withdraws funds from the company, the transaction can be characterized as compensation, a distribution or a loan. Loans aren’t taxable, but compensation is and distributions may be.
If the company is a C corporation and the transaction is considered a distribution, it can trigger double taxation. If a transaction is considered compensation, it’s deductible by the corporation, so it doesn’t result in double taxation — but it will be taxable to the owner and subject to payroll taxes.
If the company is an S corporation or other pass-through entity and the transaction is considered a distribution, there’s no entity-level tax, so double taxation won’t be an issue. But distributions reduce an owner’s tax basis, which makes it harder to deduct business losses. If the transaction is considered compensation, as with a C corporation, it will be taxable to the owner and subject to payroll taxes.
Loans to the business
There are also benefits to treating transfers of money from owners to the business as loans. If such advances are treated as contributions to equity, for example, any reimbursements by the company may be taxed as distributions.
Loan payments, on the other hand, aren’t taxable, apart from the interest, which is deductible by the company. A loan may also give the owner an advantage in the event of the company’s bankruptcy, because debt obligations are paid before equity is returned.
Is it a loan or not?
To enjoy the tax advantages of a loan, it’s important to establish that a transaction is truly a loan. Simply calling a withdrawal or advance a “loan” doesn’t make it so.
Whether a transaction is a loan is a matter of intent. It’s a loan if the borrower has an unconditional intent to repay the amount received and the lender has an unconditional intent to obtain repayment. Because the IRS and the courts aren’t mind readers, it’s critical to document loans and treat them like other arm’s-length transactions. This includes:
Also, to avoid a claim that loans to owner-employees are disguised compensation, you must ensure that they receive reasonable salaries.
If you’re considering a loan to or from your business, contact us for more details on how to help ensure it will be considered a loan by the IRS.
The TCJA’s new deduction for owners of pass-through entities can be 20% of qualified business income. But a wage-based limit applies if an owner’s taxable income exceeds certain levels. Find out how the limit works.
Midyear tax planning is important, especially this year. Here are three strategies to consider.
In late June, the U.S. Supreme Court expanded the ability of states to collect sales tax from out-of-state online retailers. If your business makes online sales to out-of-state customers, here’s what you need to know.