Who this is for
- Owners of C corporations and S corporations whose balance sheet shows loans to shareholders
- Bookkeepers and preparers asked to clear the balance before a return, a loan application or a sale
Not covered here
- Setting up a new loan from a corporation to its owner
- Loans from a shareholder to the corporation
- Working out stock and debt basis
- State corporate law limits on loans to owners, and public companies
- Canadian shareholder loans
What is a loan to shareholders on the balance sheet, and where is it on the return?
A loan to shareholders is an asset: money the corporation paid to or for an owner that the books say the owner will repay. It is line 7 of Schedule L, the balance sheet, on both Form 1120-S and Form 1120. Line 19, "Loans from shareholders", runs the other way: money an owner lent to the corporation. For that, see shareholder loans to an S corporation.
A balance often builds up when money goes to an owner with no payroll, no distribution entry and no signed note. The label in the books does not settle what the money was. It is a real loan, pay for services or a distribution, and the tax rules treat each differently.
A case is not simple when:
- the balance goes back more than one year;
- there is no note, no interest and no repayments;
- an S corporation owner who works in the business has no payroll;
- there is more than one shareholder;
- a shareholder lives outside the US;
- a lender, a buyer or a preparer is asking about the balance.
Gather a shareholder ledger by year, any notes, bank statements, prior Schedules L and Schedules K-1, payroll records and the owner's stock basis.
Three terms come up below:
- Stock basis: the owner's tax cost in the shares, raised by S corporation income passed through and lowered by losses and distributions (section 1367).
- Earnings and profits: a corporation's profits as tax law counts them. A distribution out of them is a dividend (Publication 542).
- Accumulated adjustments account (AAA): an S corporation's running total of net income not yet distributed since it became an S corporation (instructions).
Does the corporation have to file a balance sheet at all?
A corporation may skip Schedule L only when both its total receipts and its year-end total assets are under the return's small-corporation limit. The test sits in a different place on each return, and each form defines total receipts its own way:
| Return | Where the test is | If the answer is Yes |
|---|---|---|
| Form 1120-S | Schedule B, question 11: receipts and year-end assets each under $250,000 | Schedules L and M-1 are not required; Schedule M-2 is not excused |
| Form 1120 | Schedule K, question 13: receipts and year-end assets under $250,000 | Schedules L, M-1 and M-2 are not required; the corporation enters its cash distributions and the book value of its property distributions instead |
The Form 1120-S instructions and Form 1120 instructions list what counts as receipts.
The exception excuses the schedule, not the loan. The balance stays in the books, a lender or buyer may read the books, and the tax rules below apply with or without a Schedule L. For when the schedule is required and how to produce it, see Schedule L on a corporate return.
Can we cancel loans to shareholders against retained earnings?
Yes, a bookkeeper can post that entry, but it records a distribution to the owner, not a deduction, and it does not decide the tax result. It debits retained earnings (or a shareholder distributions account that closes into it) and credits loans to shareholders. The loan leaves the assets and equity falls by the same amount. The entry is right only when the facts support a distribution.
The IRS looks at what the payment was, not at the label. Publication 542 says that when a corporation cancels a shareholder's debt without repayment, the amount cancelled is treated as a distribution to the shareholder. For an S corporation, the IRS also has authority to reclassify payments to a shareholder-employee as wages (IRS).
A real loan that becomes worthless is a separate question. Section 166 allows a deduction for a debt that becomes worthless within the year, and may allow one for the charged-off part of a debt recoverable only in part, but only a bona fide debt qualifies (26 CFR 1.166-1(c)). A balance cancelled by choice is a distribution.
A book entry reports nothing by itself. The distribution still has to appear on the right return, as the next section shows.
What does cancelling a shareholder's debt do for tax: C corporation versus S corporation?
In both cases the cancelled amount is generally a distribution, not a deduction. What follows for the shareholder differs:
| C corporation | S corporation | |
|---|---|---|
| How the IRS treats it | A distribution to the shareholder (Publication 542); wages when it is pay for the owner's services | A distribution under section 1368 when paid because of stock ownership; wages when it is pay for services |
| Shareholder's tax | A dividend up to the corporation's earnings and profits; the rest lowers stock basis; any excess over basis is gain (section 301(c)) | Not income up to stock basis; any excess is gain from a sale or exchange. With accumulated earnings and profits from years as a C corporation, part can be a dividend (section 1368) |
| Corporation's deduction | None as a distribution; wages are deductible if reasonable (section 162(a)(1)) | None as a distribution; wages are deductible if reasonable (section 162(a)(1)) |
| Reporting | Form 1099-DIV, with any nondividend part in box 3; Form 5452 with the return for nondividend distributions (Publication 542; Form 1099-DIV instructions) | Schedule K line 16d and Schedule K-1 box 16, code D; Schedule M-2 (instructions) |
Publication 542 sends S corporation readers to the Form 1120-S instructions. The S corporation column rests on the Code and on the regulations, which recognize actual, constructive and deemed distributions (26 CFR 1.1361-1(l)(2)).
A C corporation's cancellation can therefore create a taxable dividend with no cash changing hands.
What are the real options for clearing a shareholder loan balance?
There are four: repay it, treat it as pay, treat it as a distribution, or keep it as a documented loan. Each has a different tax effect:
| Option | What it takes | Tax effect |
|---|---|---|
| Repay it | The shareholder pays the corporation back with the shareholder's own money | The loan ends. The interest rules below may still have applied while it was outstanding |
| Treat it as pay | The owner is an officer or employee and the money was for services; run it through payroll | Wages: payroll tax, withholding and a W-2; deductible by the corporation if reasonable |
| Treat it as a distribution | Cancel the balance and book it against equity: a distribution in the year cancelled. If the transfers were never loans, treat each as a distribution in the year taken and correct those years. With several S corporation owners, a distribution to only one raises a question for the others (see below) | C corporation: a dividend up to earnings and profits. S corporation: generally tax-free up to stock basis, gain above it |
| Keep it as a documented loan | A signed note with the amount, a repayment schedule and interest of at least the federal rate, then repayments actually made | A bona fide loan is generally not income to the owner; interest below the federal rate triggers the interest rules below |
The right option depends on facts: whether the owner did work for the corporation, what reasonable pay would be, stock basis, earnings and profits, and how many shareholders there are.
A "repayment" may not be one. The IRS summarizes a court decision that treated purported loans from an S corporation to its sole shareholder as wages: unsecured demand notes with no interest, made at the owner's discretion to an owner doing substantial work, "repaid" only by a bookkeeping credit against amounts the corporation owed the owner (IRS). Whether money is wages, a distribution or a real repayment depends on the facts.
A note signed today documents a loan from today. It does not prove that earlier advances were loans when they were made. To set up a loan properly from the start, see borrowing from your own corporation.
What interest applies to a loan from the corporation to a shareholder?
A corporation's loan to a shareholder should charge interest of at least the applicable federal rate. A loan with less is a below-market loan, and the interest not charged may be treated as a distribution to the shareholder. Section 7872 covers any loan between a corporation and any of its shareholders, and the IRS publishes the rates every month (Applicable Federal Rates).
- Demand loan (payable whenever the corporation asks): the federal short-term rate for each period, compounded semiannually.
- Term loan (fixed repayment date): the rate for its term on the day the loan was made, compounded semiannually.
- Too little interest: on a demand loan, the shareholder is treated as receiving the forgone interest from the corporation and paying it back as interest, counted on the last day of each calendar year, so the corporation is treated as receiving interest. On a term loan, the shortfall is treated as cash the shareholder received on the day the loan was made, and the loan as having original issue discount (section 7872(b)). Publication 542 calls the interest not charged a possible distribution.
- Small loans: the rule does not apply on days when all loans between the shareholder and the corporation total no more than $10,000, unless avoiding federal tax is one of the principal purposes of the interest arrangement. Loans to a shareholder and the shareholder's spouse are added together, and once the rule applies to a term loan it keeps applying (section 7872(f)(7) and (f)(10)).
A balance that has sat for years with no interest is not exempt. On a demand loan the rule is figured year by year. For the rate rules in full and a loan set up properly, see borrowing from your own corporation.
What changes if the balance is treated as wages?
The money becomes pay for services: payroll tax, withholding and a W-2 apply, and the corporation may deduct it only as reasonable pay for services actually done.
| Item | Effect |
|---|---|
| Who counts | A corporate officer who performs more than minor services and is paid or entitled to be paid is an employee for payroll tax and withholding, even when also a shareholder (IRS) |
| Payroll tax | Employer and employee each owe 6.2% Social Security on wages up to the annual wage base and 1.45% Medicare; the employer generally owes federal unemployment tax too |
| Withholding | Income tax withholding applies to the wages |
| If nothing was withheld | The corporation is liable for the employee's share (section 3102(b)) and for the income tax it should have withheld (section 3403). A responsible person who willfully fails to pay it over can owe a penalty of 100% of the tax personally (section 6672); see trust fund recovery penalty |
| Forms | A W-2 for the year paid. For a year already filed, corrected payroll returns and W-2s |
| Corporation's deduction | Compensation for services actually rendered, and only a reasonable amount (section 162(a)(1)) |
An S corporation must pay a shareholder-employee reasonable pay before it makes non-wage distributions, and the amount of reasonable pay never exceeds what the shareholder received, directly or indirectly (IRS). For what counts as reasonable, see S corporation owner salary.
Wage treatment has to be real. A journal entry that renames the balance "salary" files no payroll return. For years already filed, see fixing a payroll mistake and S corporation payroll never run.
What changes if an S corporation treats the balance as a distribution?
The distribution lowers the shareholder's stock basis and the accumulated adjustments account, and it is tax-free only up to basis.
- Reporting: the amount goes on Schedule K, line 16d, and on box 16, code D, of the Schedule K-1 of the shareholder who received it (instructions).
- Accumulated adjustments account (AAA): Schedule M-2 reduces it by distributions other than dividends from earnings and profits, but not below zero (instructions).
- Stock basis: the distribution reduces basis, but not below zero (section 1367(a)(2)). The year's income items are counted first (section 1368(d)).
- Over basis: the excess is treated as gain from the sale or exchange of property (section 1368(b)).
- Earnings and profits from an earlier C corporation period: these can turn part of a distribution into a dividend. The default order is in section 1368(c), and the corporation can elect, with the consent of every shareholder who received a distribution that year, to pay out earnings and profits first. The election is irrevocable, covers that year only and is made by a statement on a timely filed original or amended Form 1120-S (section 1368(e)(3); instructions). See distributions in excess of basis.
- Several shareholders: the regulations give distributions that differ in amount "appropriate tax effect", so one owner's cancelled balance raises a question for the others (26 CFR 1.1361-1(l)(2)). See unequal S corporation distributions.
For the entries, see recording S corporation distributions. For basis, see S corporation shareholder basis and distributions in excess of basis.
The balance goes back several years and was never papered: what do I fix first?
Decide the treatment year by year, oldest first, because each year's basis and earnings feed the next. Steps:
- Stop new unpapered transfers. From now on, every payment to an owner is payroll, a recorded distribution or a signed loan.
- Build the shareholder ledger from the bank statements: date, amount, owner and purpose for every transfer, every year.
- Check how each year was reported: Schedule L line 7, Schedules K-1, W-2s and Forms 1099-DIV.
- For each owner, compare the wages paid with reasonable pay for the work done.
- Work out stock basis and the AAA, or earnings and profits for a C corporation, year by year, so you know what a distribution would cost.
- Choose the treatment for each year's amount: repay, wages, distribution, or a documented loan from here on.
- List the filings that would change: the corporate return, Schedules K-1, payroll returns, W-2s and the owners' own returns.
The last step is where a professional is needed. A different label for an old balance can reach returns that are already filed.
For books several years behind, see S corporation catch-up books; for a buyer's review, quality of earnings for a small business sale. If the balance sheet will not balance after the entries, see an S corporation balance sheet that will not balance and retained earnings that do not match last year's return.
Example
These examples are illustrative; the amounts are in US dollars.
An S corporation owner took money for two years with no payroll
The sole shareholder of an S corporation took US$30,000 in the first year and US$50,000 in the second: US$80,000 in all, with no payroll and no paperwork. The books show US$80,000 under loans to shareholders.
- Repay: the owner pays back US$80,000. That ends the loan, if the transfers were truly loans. The interest not charged while they were outstanding may still have to be dealt with.
- Wages: at 7.65% for the employer and 7.65% for the owner, US$80,000 of wages carries US$12,240 of Social Security and Medicare tax in all (US$6,120 employer share and US$6,120 employee share; with nothing withheld, the corporation is liable for both), before income tax withholding, penalties and interest. Both years would need corrected payroll filings.
- Distribution: this assumes the transfers were never loans, so each was a distribution in the year taken and both years' Schedules K-1 and M-2 change. Suppose stock basis was US$25,000 at the start of the first year, and the corporation has no accumulated earnings and profits. In year one, US$15,000 of income lifts basis to US$40,000, and the US$30,000 distribution leaves US$10,000. In year two, US$10,000 of income lifts basis to US$20,000. Of the US$50,000 distribution, US$20,000 is tax-free and US$30,000 is gain. If they were real loans that the corporation cancels now, the whole US$80,000 is one distribution in the year of cancellation, measured against that year's basis.
Which one fits depends on stock basis and on what reasonable pay for the owner's work would have been. With no payroll at all, the wage question comes first.
A C corporation with a loan to its only shareholder
A C corporation lent US$50,000 to its only shareholder, with no note and no interest. If the corporation cancels it, the US$50,000 is a distribution. Suppose its earnings and profits cover US$30,000 of it: that part is a dividend. If the shareholder's stock basis is US$5,000, the next US$5,000 is tax-free and lowers basis to zero, and the last US$15,000 is gain. The corporation gets no deduction.
The alternatives are a signed note with interest of at least the federal rate and real repayments, or a repayment from the shareholder's own money. Because the loan is above the small-loan limit, a no-interest balance may also carry forgone interest each year.
A small S corporation under the balance sheet limit
An S corporation has receipts of US$180,000 and year-end assets of US$90,000. Both are under US$250,000, so it can answer Yes to Schedule B, question 11, and skip Schedule L. The US$30,000 it is owed by its owner is still in the books. If it is a real loan, that is above the US$10,000 small-loan limit, so with no interest it may carry forgone interest each year. Sort the balance before a lender or buyer reads the books.
Different for you?
- A preparer flagged the balance, a lender or buyer is asking, or it goes back years with no note, no interest or no payroll: whether it is repaid, recast as wages or treated as a distribution changes payroll tax, stock basis and returns already filed. That takes the ledger, the filed returns and the payroll records side by side: see corporate tax help, and bookkeeping help for rebuilding the ledger.
- A shareholder lives outside the US: a dividend to a nonresident owner can carry withholding, and the corporation, as withholding agent, is liable for tax it should have withheld (section 1461). Whether a cancellation with no cash paid triggers it is a question to settle first. A corporation with a foreign owner of 25% or more reports loans with that owner on Form 5472, and a missed filing carries a $25,000 penalty. An S corporation cannot have a nonresident alien shareholder (section 1361(b)(1)(C)). Settle this before the balance is cancelled: see paying yourself as a foreign owner and missed withholding on payments abroad.
- You want a proper loan from here on: read borrowing from your own corporation.
- The balance is mostly personal bills the S corporation paid: see S corporation paying personal expenses. For a C corporation, see C corporation paying owner expenses.
- You lent money to the corporation, not the other way round: see shareholder loans to an S corporation.
- You are in Canada: a different rule set applies; see Canadian shareholder loans.
- You took more than your stock basis: see distributions in excess of basis.
Figures on this page
| Figure | Value | Source |
|---|---|---|
| Form 1120-S test for skipping Schedules L and M-1 Schedule B, question 11: both total receipts and year-end total assets must be less than this amount. Latest final Form 1120-S is for tax year 2025. | $250,000 Tax year 2025 | IRS: Form 1120-S, Schedule B, question 11 Checked |
| Form 1120 test for skipping Schedules L, M-1 and M-2 Both total receipts (page 1, line 1a plus lines 4 through 10) and year-end total assets must be less than this amount; Schedule K, question 13. Latest final Form 1120 and instructions are for tax year 2025. | $250,000 Tax year 2025 | IRS: Instructions for Form 1120 Checked |
| Section 7872 small-loan limit for corporation-shareholder loans Aggregate outstanding loans between borrower and lender; exception does not apply if tax avoidance is a principal purpose | $10,000 | US Code: section 7872(c)(3) Checked |
| Social Security tax rate for each of employee and employer Each side pays this rate on covered wages up to the annual wage base | 6.2% Tax year 2026 | IRS: Publication 15, Employer's Tax Guide Checked |
| Medicare tax rate for each of employee and employer Each side pays this rate on covered wages; no wage base limit | 1.45% Tax year 2026 | IRS: Publication 15, Employer's Tax Guide Checked |
| Trust fund recovery penalty as a share of unpaid withheld tax Applies to the unpaid trust fund tax of a responsible person who acted willfully under IRC section 6672 | 100% | IRS: Publication 15, Employer's Tax Guide Checked |
| Foreign ownership that makes a US corporation a Form 5472 reporting corporation At least this share of vote or value held by one foreign person, directly or indirectly, at any time in the tax year. A single-member LLC wholly owned by one foreign person is treated as such a corporation. | 25% | IRS: Instructions for Form 5472 Checked |
| Form 5472 penalty for failure to file or keep records For tax years beginning after December 31, 2017. Per reporting corporation, per tax year. A substantially incomplete Form 5472 counts as a failure to file. IRC 6038A(d)(1); Treas. Reg. 1.6038A-4(a). | $25,000 | IRS: Instructions for Form 5472 Checked |
Primary sources
- IRS: Publication 542, Corporations
- IRS: S corporation compensation and medical insurance issues
- IRS: S corporation employees, shareholders and corporate officers
- IRS: Instructions for Form 1120-S
- IRS: Form 1120-S
- IRS: Instructions for Form 1120
- IRS: Form 1120
- IRS: Applicable Federal Rates
- US Code: 26 U.S.C. 162, trade or business expenses
- US Code: 26 U.S.C. 166, bad debts
- 26 CFR 1.166-1, bad debts (GovInfo)
- US Code: 26 U.S.C. 301, distributions of property
- US Code: 26 U.S.C. 1367, adjustments to basis of stock of shareholders
- US Code: 26 U.S.C. 1368, distributions
- US Code: 26 U.S.C. 7872, loans with below-market interest rates
- 26 CFR 1.1361-1, S corporation defined (GovInfo)
- IRS: Instructions for Form 5472
- IRS: Withholding on U.S. source income paid to nonresident aliens
- IRS: Instructions for Form 1099-DIV
- US Code: 26 U.S.C. 3102, deduction of employee tax from wages
- US Code: 26 U.S.C. 3403, employer liability for withholding
- US Code: 26 U.S.C. 6672, failure to collect and pay over tax
- US Code: 26 U.S.C. 1461, liability for withheld tax
- US Code: 26 U.S.C. 1361, S corporation defined
About this guide
Published by Cloud Accounting under standing professional approval. This version has no separately recorded personal review. It explains general rules for the tax year shown. It is not advice for your situation.
Changes
- : First published.