Borrow From Your Own S Corp or C Corp: Loan, Distribution or Pay

Can I borrow money from my own S corp or C corp?

Federal tax law allows a corporation to lend money to its owner, and the return has a place for it: Schedule L, line 7 of both Form 1120-S and Form 1120 is "Loans to shareholders". State corporate law varies and may limit loans to officers and directors, so this page covers federal tax only. Section 7872 sets interest rules for a loan, direct or indirect, between a corporation and any of its shareholders. The hard part is showing it is a real loan: a written note and repayments actually made, with interest at or above the federal rate. Interest below the rate does not by itself end the loan, but section 7872 taxes the shortfall as if it were paid. With no real debt, the IRS can treat the money as a distribution, a dividend or wages. In an S corporation a distribution is tax-free up to the owner's stock basis, then gain; in a C corporation it is a dividend to the extent of earnings and profits.

A case is not simple when:

• the balance is large, older than a year, or rises each year;
• there is no signed note, no interest or no payment, or you have no plan to repay it;
• the owner of an S corporation works in the business and is not on payroll;
• a C corporation has earnings and profits, the tax measure that decides whether a payout is a dividend;
• the owner's stock basis, roughly the tax cost of the shares adjusted each year, is thin.

Gather every transfer to the owner by date, any note, the balance sheet and Schedule L from prior returns, the prior balance, stock basis records and payroll records.

What makes it a real loan and not a distribution, a dividend or wages?

A loan is real when the facts show a debt that is owed and repaid, whatever the books call it. The Code does not list required loan terms, so the test is the facts. A nonbinding IRS Chief Counsel memo summarizing court decisions asks, for a wholly owned corporation, whether both sides intended repayment when the money was taken. Its factors include collateral, a set maturity date, steps to enforce repayment, the owner's ability to repay and payments actually made (IRS memo). The IRS's own summary of one federal court case shows what failed: purported loans to an owner-officer were wages for employment tax because they were unsecured demand notes with no interest, made at the owner's discretion to an owner who did substantial work, and "repaid" only by a bookkeeping credit against amounts the corporation owed the owner (IRS).

To set one up:

1. Before the money moves, sign a note with the amount, a rate at or above the federal rate for its term (next section), the payment dates and the final due date.
2. Pay from your own money on the dates set.
3. Book each advance, interest charge and payment as its own entry (see the books section below).

An S corporation owner who works in the business and takes money with no payroll is the pattern the IRS can reclassify as wages (IRS). A note written today covers the loan from today. Whether it changes how earlier advances are treated is a question about the facts of those years.

Do I have to charge interest, and what is the federal rate?

The Code does not force you to charge interest, but it taxes the shortfall as if the interest had been paid, so the safe line is the applicable federal rate (AFR) or more. A loan with no interest, or interest below the AFR, is a below-market loan, and the interest not charged is called forgone interest (section 7872).

The rate depends on the kind of loan, and its term counts options to renew or extend (section 1274(d)):

The Code lets regulations treat a loan with no fixed maturity as a demand loan. The IRS publishes the rates each month as a revenue ruling, listed on its Applicable Federal Rates page. Table 1 of each ruling gives every rate for annual, semiannual, quarterly and monthly compounding; read the column that matches how often your note pays interest, so a note that pays once a year uses the annual column.

If the interest is too low:

• Demand loan: the forgone interest for each year is treated as paid by the corporation to the owner and paid back as interest on the last day of the calendar year, so the corporation has interest income it did not collect.
• Term loan: the shortfall is treated as cash the owner received on the day the loan is made, or on the first day the section applies to it if later, and the loan is treated as having original issue discount, which is interest that accrues over the life of the loan.
• What the payment is: Publication 542 says the interest not charged may be treated as a distribution to the shareholder, depending on the substance of the transaction. For an S corporation, the regulations give an example of a below-market loan treated as a distribution that does not by itself create a second class of stock, unless a principal purpose is to get around the one-class rule.

Section 7872 does not apply on any day when all loans between the owner and the corporation total no more than $10,000, unless avoiding federal tax is one of the principal purposes of the interest arrangement. Spouses count as one person here, so loans to a shareholder and to the shareholder's spouse are added together (section 7872(f)(7)). For a term loan, once the section applies on any day it keeps applying to that loan (section 7872(f)(10)). That exception is about interest only. It says nothing about whether a small advance with no note and no repayment is a loan at all.

Shareholder loan vs distribution vs owner's draw: what is the difference?

A loan is money the owner owes back. A distribution is a payout on the owner's stock, called a dividend when it comes out of a C corporation's earnings and profits. Wages are pay for work. "Draw" is a bookkeeping word from sole proprietorships and LLCs; for a corporation, the facts decide which of the three the money was, not the word.

What happens if the IRS treats the money as a distribution or as pay?

Money that is not a real loan is taxed as what it is: a distribution, a dividend or wages. The result differs for an S corporation and a C corporation.

An S corporation owner faces the basis test and the wage question; a C corporation owner faces tax on a dividend the corporation cannot deduct (Publication 542).

Where does the loan show on the books and the return (due from shareholder, Schedule L)?

A loan to an owner is an asset, not an expense and not equity. Keep a "loans to shareholders" (due from shareholder) account with one ledger line per owner, and record each advance, each interest charge and each repayment as its own entry so the balance rolls forward.

On the return, the balance is Schedule L, line 7, "Loans to shareholders", with a beginning-of-year and an end-of-year column (Form 1120-S; Form 1120). A C corporation reports the interest it receives on Form 1120, line 5. An S corporation reports it on Schedule K, line 4, interest income, which passes through to the shareholders. A small corporation may be excused from Schedule L, but the books still carry the loan; see Schedule L on a corporate return.

How do I repay it, and when should the balance be cleared?

Cash paid from the owner's own money on the dates in the note is the clearest sign that the loan was real. Federal tax law sets no repayment deadline for a real loan; the note's due date and the interest rules govern.

Other ways to clear a balance change the tax result:

• Netting against pay or a distribution: the pay is still wages and the distribution still follows the distribution rules.
• Cancelling it: Publication 542 treats a debt the corporation cancels without repayment as a distribution to the shareholder; for an owner who works in the business, the facts can instead make it pay.

A balance past its due date with no payment and no written extension is harder to show as a real loan. For a balance already on the books, see loans to shareholders on the balance sheet.

Example

These examples are illustrative; the amounts are in US dollars and the federal rate is a round 4% chosen for easy arithmetic. A real note uses the published rate for the month the loan is made.

A C corporation lends under a signed note

A C corporation lends its only owner $30,000 on January 1 under a signed three-year note at the federal rate (4% here), with $10,000 of principal due each December 31 plus interest.

• Year 1: interest is $1,200; the balance after the payment is $20,000.
• Year 2: interest is $800; the balance is $10,000.
• Year 3: interest is $400; the balance is zero.

These are features that support a real loan. The balance sits on Schedule L, line 7, and the corporation reports each year's interest on Form 1120, line 5. The principal payments are not income.

An S corporation advance with no paper

An S corporation pays its only shareholder, who runs the business, $30,000 on January 1 of year 1. There is no note, no interest and no payment in year 1 or year 2, and the books show $30,000 under loans to shareholders each year-end.

• As a loan: assume it is payable in full on demand. The balance is over the $10,000 small-loan limit, so at 4% the forgone interest is about $1,200 in each year, treated as paid to the owner and returned as interest at each year-end. A term loan uses the up-front rules above instead.
• As a distribution: suppose stock basis is $20,000 after year 1 income and the corporation has no accumulated earnings and profits. $20,000 is tax-free, basis falls to zero, and $10,000 is gain.
• As wages: the $30,000 would be pay for the owner's work, with payroll tax and reporting for year 1.

The facts decide which result applies. An unsecured, interest-free balance that was never paid down can look like the second or third.

A small advance

An owner borrows $8,000 under a signed note. Total loans between the owner and the corporation stay at or under $10,000, so the interest rules generally do not apply. If the owner then takes another $5,000 while the first is unpaid, the total is $13,000 and the rules apply on each day the total is over $10,000; for a term loan, once they apply they keep applying to that loan, as above. A signed note helps document either advance, but both sides must intend repayment and act on it, and the small-loan exception does not make an advance a loan.

Different for you?

• The balance is large, older than a year, has no note or interest, or you have no plan to repay it: whether to document it as a loan, treat it as a distribution or add pay changes the corporation's return, payroll and your own return. Settle that with corporate tax help, and rebuild the ledger with bookkeeping help. See also loans to shareholders on the balance sheet.
• You lent money to the corporation, not the other way round: see shareholder loans to an S corporation.
• The corporation paid your personal bills: for an S corporation, see S corporation paying personal expenses. For a C corporation, see C corporation paying owner expenses.
• You want to pay yourself mainly through C corporation dividends: see C corporation owner dividends.
• You work in the S corporation and take no salary: see S corporation owner salary.
• You took more than your stock basis: see distributions in excess of basis.
• The S corporation has more than one shareholder: a payout to one owner raises a separate question; see unequal S corporation distributions.
• You own a C corporation and are not a US citizen or resident: a payout treated as a dividend can carry US withholding, and the corporation, as withholding agent, is personally liable for tax it should have withheld (Publication 515), so plan the note and the repayments before the money moves, with cross-border tax help.
• Your business is an LLC or sole proprietorship that takes draws: see recording owner's draws.