Discussion:Interest on shareholder loan
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Discussion Forum Index --> Tax Questions --> Interest on shareholder loan
| 12 January 2007 | |
| Could anyone tell me the rationale behind charging interest on loans to or from S-corp? Say you have 5% interest on a $20k loan, interest = $2k. It is interest income to the shareholder reported on 1040 and interest expense on 1120s which flows to the shareholder. It is a wash, why bother? I'd appreciate any comments or feedback. Thank you. | |
| January 12, 2007 | |
| The $2K of interest income on the shareholder's personal tax return could affect (reduce) other deductions on his return. It could also increase the taxable social security. Just a couple of reasons... | |
| 12 January 2007 | |
| The interest charge is a key part of an arms length transaction. I think the regs speak to a corporation actually, it's the same for a C-corp, and perhaps was designed to control c-corps initially. Also, the parity in your example assumes a 100 % owned s-corp, many are not. | |
| January 12, 2007 | |
| It definitely establishes the reality of the underlying debt, as Will says. And, think of it as one more way to get income out of the S without SS taxes or payroll related issues...like self rent for a building. | |
| 12 January 2007 | |
| Normally, these loan type situations involve a 100% shareholder.
However, there are S Corps with more than 1 shareholder, but only 1 would loan the corporation money. In that circumstance, it would make a difference - because interest expense reduces the corporation's taxable income - and all shareholders would be effected. However, the interest income to the loan shareholder would only effect his/her 1040. | |
| 12 January 2007 | |
| Another reason is if the shareholder borrows from the corporation, the interest would possible be nondeductible on the 1040, but the corporation still would need to pick up the interest income. | |
| 12 January 2007 | |
| Thank you, and thank you for your posts. I learn everyday. One correction as Jdugancpa pointed: 5% on 20k = $1k; sorry for the poor mental math. You guys and gals have a wonderful day! | |
| 10 July 2007 | |
| So now at the end of the year (2006) client has distributions in excess of basis so we are going to set up a note at 12/31/2006. Do I use the ST monthly or semi-annual or annual AFR rate to calculate interest receivable? Also, is this really income to the S Corp in 2006 even though the 100% cash basis S/H will not pay the interest to the S Corp until the following year - 2007? Seems like the S/H will get the interest expense deduction in 2007 so there would not be a proper matching of income and expense in 2006. | |
| 11 July 2007 | |
| 1) If you do not charge interest then the IRS may argue that the loan is a contribution of capital. To help support that you have a loan, there should be a note with terms, payments and interest.
2) Interest income can free up investment interest expense that may otherwise be suspended. 3) It the interest rate on your loan is 10% or even 15% you may be getting a better return on your investment. | |
| 11 July 2007 | |
| For 2005, I am going to use the monthly rate at the time the shareholder made the loan to the C Corp and book the interest on the books as well as the tax return as Interest Expense. Then, I am going to make an M-1 adjustment because I don't believe it's deductible due to 267. The loan to the C Corp was paid back in 2006 when the Corp became an S Corp.
For 2006, I am going to use the monthly rate at the time the S Corp (former C Corp) made the loan to the Shareholder (12/31/06)and show the interest income on both the books and the tax return. I think this is interest income to the S Corp (accrual basis taxpayer) even though the loan has not been paid by the 100% sole shareholder but I am not going to use the interest amount on the 2006 1040 as an interest expense deduction because the cash basis SH had not paid it. Anything wrong with this scenario? | |
| July 11, 2007 | |
| Interest will be recognized by the corp and S/h at the same time. And I use the midterm rate in the month that the note is created, Dec. usually. | |
| July 11, 2007 | |
| Actually round up the rate so that you're out of the rules for those notes and have some leeway. | |
| 11 July 2007 | |
| Thanks, JR1. What do you mean that "Interest will be recognized by the corp and S/h at the same time"? I thought that if the loan was with a related party, particularly a cash basis related party, that there were related party rules at Section 267 that would change some of the recognition. | |
| 11 July 2007 | |
| OK. I have read 267(a)(2) and it states that "An accrual basis taxpayer can deduct expenses and interest owed to a related cash basis person when payment is made and the amount involved is includible in the gross income of the cash basis payee. In other words, an accrual basis taxpayer is treated as being on the cash method of accounting for purposes of deducting amounts owed to related cash basis persons."
Given that code section, I now undertand what you stated above, JR1, and I plan to use 5% compounded annual rate (rounding up the midterm rate)and then match the interest expense/income to the same year for both the Corp and the shareholder. Got it. Can I make the payment of the interest via a journal entry against S/H distribution in 2007 to wipe it out? Thanks... | |
Michaelstar (talk|edits) said: | 11 July 2007 |
| Chase (and JR1) I would use the short term rates and not the midterm rates just as a matter of course because midterm rates imply a greater than 3 year loan. Unless that was expected - the short term rate adjusted semiannual would be the direction I would go. Force me and I'll look up the code section in the morning...... It is in the files.
With you using a 5% rate - that would be okay for now as the AFR's for July 2007 are a pinch lower - 4.91% - s/t, 4.89% mid-term, semiannual. You will want to pay attention to this so that your rate does not end up below the AFR (as you are very close to the line) and you end up needing to deal with the below maket rates issues. | |
| 11 July 2007 | |
| Regarding interest on reclassifying distributions in excess of basis as loans, is it correct that the corporation will have interest income and the owner interest expense, and that whether the owner's interest is deductible will depend on what the proceeds were used for, under interest tracing rules?
Also, I've seen loan documents under which the lender has the option to decide whether to allocate payments received to interest vs. principal. Does this seem OK? It might be very useful. Thanks | |
| 11 July 2007 | |
| I read somewhere that the ST rates should be used as well. But could not find anything about the semi-annual. I used to know where to go for this but have not been able to find that particular source. So, thanks for the info (if you can find it.) | |
| July 11, 2007 | |
| I like Michael's argument. If you assume that the note is being re-written each year, that makes sense. But are we really setting up one year payout schedules on these? Of course not...If there's a requirement to use ST, let us know. And, yes, I often book the interest to the S/H note, and issue the 1099INT, picking up the expense on the corp and the income on the 1040. No tracing necessary Smokey. The interest usually goes the other way. Corp has the expense and the S/H has the income. | |
Michaelstar (talk|edits) said: | 11 July 2007 |
| Chase - look at reg 1.7872-3, 1.7872-12 and 13. These regs are not to long but great reading and should provide you with guidance on this.
JR1 - there is not a requirement to use ST in this case. ST just implies the loan will o/s from 0-3 years. The rate of 5% in above the current minimum rate for either ST or Mid Term. | |
| 12 July 2007 | |
| Thanks. I went with 5.5% and then pushed the interest against the shareholder note. I calculated the compound interest on the note for each month because I had pay downs on the note which went against the principle. Took me a while and I might have made it more complicated than I needed to but I think it makes sense. I appreciate the reference and have the Reg. on my reading list for tomorrow. | |
| July 12, 2007 | |
| And without looking, I think that that's the section you dodge by having your rate just above the AFR, so most of the rules of it don't apply, tho' holding to the proper form keeps you out of trouble. | |
Tpfernandez (talk|edits) said: | 12 July 2007 |
| If 2 unrelated S-corporation shareholders do not have formal paperwork designating initial funding of the corp. between debt or capital, can they choose how to allocate the funding? If so, how would they go about doing so? | |
| 12 July 2007 | |
| There s/b a note that states what the interest is and how frequently it's paid. | |
Tpfernandez (talk|edits) said: | 12 July 2007 |
| Thank you Blrgcpa. JR1, I've seen some of your posts regarding shareholder loans and initial capitalization which I am not sure how to interpret. Is it okay to do loans as part of initial funding? What should be considered. When loans are used as basis to deduct losses, do you treat repayment of them as ordinary income? | |
| July 12, 2007 | |
| To me, Sec. 351 has always been crystal clear that you cannot bring debt into the initial capitalization of a corp and have it be tax free. One court case that Riley likes to bring out, 8th Circuit as I recall, P..Italian name...(which I'll bet will be overturned somewhere along the way..) Peracci? ruled otherwise. So I do not ever allow debt into the opening entry. Debt can come in later. 60 days? 90? And just be sure to allocate your capital in accordance with the share ownership. If loan payments are made after exhausting basis, assuming the notes are written, my understanding is that they're cap gains. | |
| 12 July 2007 | |
| When self-charged interest is reported on Schedule E does that then increase the shareholder basis? | |
| July 12, 2007 | |
| The interest that isn't actually paid in cash, but added to the note, increases the basis in the note until it's paid cash, of course. | |
| 26 October 2007 | |
| Regarding Section 351: it does not apply to loans from shareholders to the corporation IMO. It says: "IRC §351: "No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control…of the corporation." If the shareholder makes a loan to the corporation from day one and does not receive stock for the loan, then Sec. 351 is not applicable. In the initial "Shareholder Agreement", the corporation should set forth the actual paid-in capital (either cash or property or past services--note: services are taxable) and the percentage of shares of stock received for actual paid-in capital. A loan to the corporation cannot be used in exchange for stock. There is no time period or wait period before the corporation can receive a loan from shareholders since this is not in exchange for stock. However, documentation is important. Be sure to record stock issued for paid-in capital. | |
| 26 October 2007 | |
| I have been reading all the various S-corp threads and I have a few questions. I know if it is 100% controlled by a s/h the loan is basically a wash but must still accrue interest to be arms length if over $10K. What is there are two shareholders, husband and wife, and the husband loans the money to the s-corp? That should also be a wash if they file jointly, correct?
Also, the loans to the s-corp were over two months apart. Each loan is under $10K but together they are over $10K. Does the loan still need to accrue interest or does each qualify under the $10K de minimus? Thanks | |
| 15 October 2008 | |
| Hi!
I am a newbie ;o)) Here is my "theoretical question". A C-Corp shareholder has set up a "credit card" accounting entry (with documentation for fair-market interest and repayment terms). As expenses come due the C-Corp takes cash advances from the credit card to pay expenses. Some of these expenses are paid on behalf of an S-Corp owned by the shareholder and are invoiced accordingly. Neither corporation has had any income to speak of for two years. No losses have been claimed as tax deductions by the shareholder for several years (i.e., 0 income, 0 loss). The S-Corp will start accruing income in two months at a rate sufficient to start paying the outstanding invoices. 1) What are the tax consequences of the C-Corp then making payments towards the outstanding credit-card debt (i.e., to both the C-Corp and the shareholder)? 2) Can the interest payments be deferred (i.e., can the principal be paid off first)? | |
Taxlady1941 (talk|edits) said: | 13 April 2011 |
| I have read all discussions. I get from this that an S-Corp can accrue interest on Shareholder loans for future payment, but can not take a tax deduction. Is this correct? | |
Harry Boscoe (talk|edits) said: | 13 April 2011 |
| ...but cannot take a tax deduction until the payee-shareholder has taxable income if it is the accounting methods of the two parties that causes the accrual of interest *not* to be income to the shareholder at the time of the accrual. That is from memory and should not be trusted.
Who's been in my fridge? I coulda sworn there was at least a ... Oh, never mind. | |
