S Corp Shareholder Loan vs Capital Contribution: Debt Basis

Should I book money I put into my S corp as a loan or as capital?

Money you put into an S corporation is a loan only when it is real debt the corporation owes you. Money that is not a loan is generally a capital contribution. The two sit in different places on the balance sheet and give you different basis, so the label has to match the facts.

The balance sheet lines come from Form 1120-S and the basis rows from the Form 7203 instructions. A label decides nothing by itself: whether money is a bona fide loan depends on all the facts and circumstances (26 CFR 1.1366-2(a)(2)). Decide before the money moves; a label added later still has to be supported by the facts.

A case is not simple when:

• there is no note, or the terms were never followed;
• the corporation has passed losses through to you, or your distributions may exceed your stock basis;
• a loan is being repaid, or was repaid, after losses reduced its basis;
• you guaranteed a bank loan, or lent through another company or a relative;
• you want to relabel money you spent for the company in earlier years as a loan.

Gather: bank records of every transfer in and out, including any foreign account the money came from, any note or loan agreement, every Schedule K-1 (Item I and box 16), Form 7203 or your basis records, and the corporation's balance sheet.

What makes a shareholder loan real debt?

A shareholder loan is real debt when it is bona fide indebtedness that runs directly from the corporation to you, judged on all the facts and circumstances (26 CFR 1.1366-2(a)(2)). The rule gives no checklist. These facts show that both sides treated the money as debt:

• a signed note stating the amount, the interest rate and the repayment dates;
• a dated transfer from your own account to the corporation's;
• a liability on the corporation's books, and a balance reported to you each year;
• interest paid or accrued as the note says;
• principal repaid on schedule, or a written change when it is not.

The debt must run to you. A loan made through an entity that is disregarded as separate from you, such as a single-member LLC, counts the same (26 CFR 1.1366-2(a)(2)(iii), Example 1). A back-to-back loan, where you borrow elsewhere and lend the money on, is tested on its facts. Money the corporation owes a relative, or a company you own that is not disregarded, generally does not run directly to you.

This matters when the money came from a parent, a spouse, a joint account or an overseas account. If you moved it in as your own money, keep the transfer records that show where it came from. If the relative lent it to the corporation, that relative is the lender and you generally have no debt basis from it.

Can a shareholder loan put the S election at risk?

An S corporation can have only one class of stock, and a second class could cost it its S status (section 1361(b)(1)(D)). A shareholder loan that fits the straight-debt rule is not a second class of stock. That rule needs (section 1361(c)(5); 26 CFR 1.1361-1(l)(5)):

• a written, unconditional promise to pay a fixed sum on demand or on a set date, though not necessarily a formal note;
• interest and payment dates that do not depend on profits or on the corporation's choice;
• no way to convert the loan into stock;
• a lender who is an individual (other than a nonresident alien), an estate, a trust described in section 1361(c)(2) or a person actively and regularly in the business of lending money.

Two more safe harbors apply (26 CFR 1.1361-1(l)(4)(ii)(B)):

• Unwritten advances. No more than $10,000 in total at any time in the year, treated as debt by the parties and expected to be repaid within a reasonable time.
• Loans held in proportion to stock. Obligations of the same class that are treated as equity, owned only by the shareholders and in the same proportion as their stock, are not a second class of stock. Matching loan balances alone are not enough if the obligations are of different classes. A sole shareholder's obligations always qualify.

The proportion rule protects the election only; whether the money is debt for basis still turns on the facts. A loan outside these safe harbors is not automatically a second class of stock. An obligation treated as equity under general tax principles also needs a principal purpose of getting around the stock's distribution or liquidation rights or the limits on who can be a shareholder. Convertible debt has a separate test: conversion rights that work like a call option can create a second class of stock without that purpose (26 CFR 1.1361-1(l)(4)(iv)). Have profit-based or convertible terms reviewed before they are signed.

Does a shareholder loan give me basis, and how is debt basis different from stock basis?

Yes. A bona fide loan from you gives you debt basis (the IRS also says loan basis) equal to the balance the corporation owes you, reduced by losses and restored by later income (Form 7203 instructions). Debt basis is kept apart from stock basis, and the two work differently.

Sources for the table: Form 7203 instructions; section 1367(b)(2). Two more points about debt basis:

• Debt basis is figured at the close of the corporation's tax year (26 CFR 1.1367-2(d)), so a loan made after year-end counts only for later years. A loan the corporation repays before year-end is not held at the close, so it absorbs none of that year's loss (26 CFR 1.1367-2(b)(1)).
• You, not the corporation, keep the basis records. The Schedule K-1 only helps you figure them (Form 7203 instructions).

A loan repayment is one of the events that requires Form 7203 (Form 7203 instructions). For who files it and the year-by-year build, see S corporation shareholder basis.

How do I record a shareholder loan in the books, and where does it show on Schedule L and the K-1?

Record the money in as cash and a liability, with one account for each shareholder. A capital contribution goes to equity instead. Account names are bookkeeping practice, not IRS rules.

Keep each written note in its own sub-account. Form 7203 tracks every written note in its own column, and advances with no separate paper form one combined open-account balance (Form 7203 instructions).

If one account has held money in and money out, do not leave it as a single running balance. Split it by purpose: what you lent, what you contributed, repayments, distributions, and anything the corporation paid for you personally. If you end the year owing the corporation, that is a loan to you, not from you, and it sits on a different line (Schedule L, line 7 on Form 1120-S); see borrowing from your own corporation and loans to shareholders on the balance sheet.

On the return, the year-end balance goes on Schedule L, line 19 (Loans from shareholders), unless the corporation answers Yes to Schedule B, question 11 (small receipts and assets), which excuses Schedule L. Each shareholder's balance at the start and end of the year goes in Item I of that shareholder's Schedule K-1. Line 19 should generally reconcile to the K-1 total, and Item I leaves out debt you only guaranteed or co-signed (Instructions for Form 1120-S; Schedule K-1).

What interest can an S corporation pay me on a shareholder loan?

The corporation can pay interest on a real loan, and a rate below the applicable federal rate, or no interest at all, can bring in section 7872. Under that section, a loan between a corporation and any of its shareholders that carries too little interest is a below-market loan, and the tax code can treat the missing interest as paid (section 7872).

• Benchmark. For a demand loan it is the federal short-term rate. For a term loan it is the applicable federal rate in effect on the day the loan is made (section 7872(f)(2)). The IRS publishes the rates monthly (Applicable Federal Rates).
• Small loans. The rule does not apply on days when all loans between you and the corporation total no more than $10,000, unless avoiding tax is a principal purpose (section 7872(c)(3)). Once the rule applies to a term loan, it keeps applying even if the balance later falls below that limit (section 7872(f)(10)).
• Rate too high. Interest on straight debt is treated as interest by both sides and is not a distribution. If the rate is unreasonably high, an appropriate part can be recharacterized as something other than interest (26 CFR 1.1361-1(l)(5)(iv)).

How each side is taxed:

• The corporation deducts interest on money it uses in its business on Form 1120-S, line 13, within the business interest limit. Interest tied to rental property or investments is reported elsewhere (Instructions for Form 1120-S).
• You report the interest as interest income on your own return. The corporation may have to file Form 1099-INT. For interest on a note issued in registered form or of a type offered to the public, reporting starts at $10 (section 6049). For other interest an operating business pays, it starts once payments reach $2,000 in a year (section 6041). The printed Form 1099-INT instructions still show the older, lower section 6041 amount.
• Timing. If the corporation accrues interest it has not paid and you report income when paid, its deduction waits until you include the interest. The law treats any owner of S corporation stock as related for this rule (section 267(a)(2) and (e)).

How do I take the money back out: loan repayment or distribution?

A loan comes back as a repayment of principal. Capital comes back only as a distribution. The tax and the reporting differ.

• Loan repayment. The corporation reports it on Schedule K, line 16e, and on your K-1 in box 16, code E (Instructions for Form 1120-S). On Form 7203 only the principal portion counts; interest is not a repayment (Form 7203).
• Distribution. For a non-dividend distribution, stock basis alone is the test, and the part above that basis is capital gain. A loan you made does not protect a distribution (IRS: stock and debt basis). A corporation with earnings from C corporation years can also pay taxable dividends. See distributions in excess of basis and recording S corporation distributions.

With more than one owner, returning only one owner's capital is a distribution the others do not get. A real loan repaid on its terms is a debt repayment instead, and the facts decide which it is. See unequal S corporation distributions.

Does repaying a shareholder loan ever create tax?

Yes, when losses have reduced the loan's basis and later income has not restored it. The tax-free part of a repayment is the share of the loan that still has basis, and the rest is gain (Form 7203; K-1 instructions, box 16 code E). For a written note, if a quarter of the loan still has basis after any restoration, a quarter of each principal repayment is tax-free. For open account advances, the year's advances and repayments are netted at year-end, and only a net repayment counts (26 CFR 1.1367-2(d)(2); Form 7203 instructions, line 19).

Source: Form 7203 instructions. Gain on a repayment does not add basis.

If the open-account balance (advances less repayments) is above $25,000 at the end of a corporate year, it is treated like a written note for basis adjustments from the next year on, and the netting above stops for that balance (26 CFR 1.1367-2(a)(2)). Yet the Form 7203 instructions still report gain on open account debt, that larger balance included, as ordinary gain. They point both ways on the character of that gain (lines 17 and 34), so have it reviewed before a balance that passed that line is repaid.

A net increase for the year (income items less losses, deductions, nondeductible expenses and distributions) restores reduced loan basis first, effective just before the repayment. It reaches only loans you held at the start of that year, and never above the loan's face (26 CFR 1.1367-2(c)(1) and (d)(1); Form 7203 instructions, line 23). Loan basis decides how much of a repayment is gain, so it is worth working out before a repayment in a year the corporation passed losses to you.

What if the corporation borrowed from a bank and I guaranteed the loan?

A guarantee or co-signature gives you no debt basis by itself. You gain basis only when you make a payment on the loan under the guarantee, and only up to that payment (26 CFR 1.1366-2(a)(2)(ii); Form 7203 instructions).

The bank loan stays on the books as the corporation's debt to the bank, and Item I on your K-1 leaves it out. If you pay under the guarantee, keep the guarantee, the bank's record of your payments and a written record of what the corporation now owes you.

Can I turn expenses I paid for the company into a loan now?

Papers dated today can be weak proof that earlier payments were loans. Debt basis needs bona fide debt, judged on all the facts and circumstances. No rule says a later note is always ignored or always accepted, so the facts decide (26 CFR 1.1366-2(a)(2)).

A note signed today shows an agreement from today. If no one recorded a liability, charged interest or repaid anything when the money moved, the IRS can question whether it was ever a loan. The IRS also says to consider whether the shareholder had the means to make a claimed loan or contribution, so keep the bank records (IRS: stock and debt basis).

Going forward, document the treatment when the money moves: a note signed on the day you lend, or a reimbursement under an accountable plan. See reimbursing owner expenses and S corporation expenses never reimbursed.

How do loan basis and stock basis limit the losses I can deduct?

The losses and deductions an S corporation passes to you cannot exceed your stock basis plus your loan basis. The excess is suspended, keeps its character and carries forward without limit (section 1366(d); Form 7203 instructions).

• Order. By default, stock basis is raised by income, then lowered by distributions, then nondeductible expenses, then losses. Distributions use stock basis before a loss does, and only the part of a loss that stock basis can no longer cover reduces loan basis (section 1367(a) and (b)(2); 26 CFR 1.1367-1(f); IRS: stock and debt basis).
• Election. Each shareholder can elect under 26 CFR 1.1367-1(g) to take losses before nondeductible expenses, so nondeductible expenses above stock and loan basis carry forward instead of being lost. The statement goes with a timely filed original or amended return, names the corporation, and applies to later years unless the IRS permits revocation (Form 7203 instructions).
• Restoring basis. A later net increase (income left after that year's losses, deductions, nondeductible expenses and distributions) restores loan basis first, up to what the corporation owes you, and only then raises stock basis. A suspended loss becomes deductible as basis comes back.
• Lost losses. Suspended losses are generally lost if you dispose of all your stock (IRS: stock and debt basis). Two exceptions: stock transferred to a spouse or former spouse under section 1041 passes the losses to the transferee, and if S status ends they can still be used in the short window after it ends (the post-termination transition period), against stock basis only (section 1366(d)(2)(B) and (3)).
• Other limits. Basis comes first. The at-risk, passive activity and excess business loss limits apply after it (Form 7203 instructions).

Example

These examples are illustrative; all figures are in US dollars.

A signed note

An owner puts $50,000 into working capital under a signed five-year note at 6% (assume that is at least the applicable federal rate). The corporation books $50,000 as a loan from shareholder, Schedule L line 19. The owner gets $50,000 of debt basis. If no principal is repaid in the first year, the corporation pays $3,000 of interest: a business deduction for the corporation and interest income for the owner.

No note and no repayment plan

The same $50,000 goes in with no note, no interest and no plan to repay. The facts may not support a loan. Money put in that way is generally booked as a capital contribution (additional paid-in capital), which adds $50,000 of stock basis. Taking it back later is a distribution, tested against stock basis. Advances with no note can still be debt, but the proof is thinner.

Losses, basis and a repayment

An owner lends $40,000 under a note and has $10,000 of stock basis. The corporation loses $30,000 in each of two years, with no income or distributions.

Total basis was $50,000, so $50,000 of the $60,000 loss is allowed and $10,000 carries forward. In year 3 the corporation repays the $40,000 and has no net income. Loan basis is zero, so none of the repayment is tax-free: the $40,000 is capital gain because the loan was a written note. A net increase in year 3 would restore loan basis first and cut that gain.

Different for you?

• Losses were claimed, a distribution may exceed stock basis, or there is no note: whether the money is debt or capital, the loan balance shown on each K-1 and the entries that support it all turn on your records. Get bookkeeping help to settle them before the next return relies on them, and see S corporation shareholder basis.
• A loan is about to be repaid after losses reduced its basis: tax can fall on the repayment, so work out loan basis first with corporate tax help, and have the books show what was lent and repaid with bookkeeping help.
• You guaranteed a bank loan, or the money came through another company, a relative or a joint account: debt basis may be zero until you pay, or the loan may not run to you at all. Get bookkeeping help to sort out who lent what before the return is filed.
• Past returns used losses or basis you cannot support: see distributions in excess of basis and get corporate tax help before correcting them.
• The corporation lent money to you instead: see borrowing from your own corporation.
• You paid company expenses and were never repaid: see S corporation expenses never reimbursed.
• The business is an LLC, not an S corporation: see owner contribution or loan to your LLC.
• The books are behind or the balance sheet will not tie to the return: see S corporation bookkeeping and get bookkeeping help.