Loans between C Corporation and Shareholders

Posted on May 26, 2024

SHAREHOLDER LOANS

There could be different kinds of transactions between a corporation and its shareholders but mainly are classified in the following two categories:

Equity Transactions - which mainly comprises of the following:

• Any contribution made by the shareholders to the corporation or
• Any distribution from the corporation to the shareholders

Debt Based Transactions - which have to be well documented -

• Corporations are required to charge interest on the loans forwarded to the shareholders. As per the IRC guidance, the rate of interest on these loans has to be either at or above the Applicable Federal Rate (AFR) - IF NOT- there will be Imputed Interest.
• Just to explain in simple terms, the IRS wants the loans to the shareholders provided by the corporation at or above a fixed federal rate and the interest income, as earned by the corporations from these loans, is considered taxable interest income.
• But if the corporation provides loans below the AFR, there will be IMPUTED INTEREST

Imputed Interest

• It is mainly the difference between :
• the Applicable Federal Rate (AFR) and
• the actual rate charged on the below-market loan

Example :

If AFR = 3% on a loan of $100,000 with zero percentage, between a shareholder and a corporation- it would generate $3,000 imputed interest income to the lender and imputed interest expense to the borrower annually.

Imputed Income to Shareholders- Borrowers

We discussed above on the imputed interest expense, which can come into existence if corporations provide loans to shareholders below the AFR.

However, the imputed interest can be treated as a dividend income for the shareholders in the following scenarios:

• If the shareholder is not an employee of the corporation and the corporation has enough E&P, the imputed interest can constitute taxable dividend for the shareholders
• What if the shareholder is an "employee" of the corporation ?? In such a case, the imputed interest can still be treated as a taxable dividend to the shareholder if the shareholder owns more than a "de minimis" amount of stock
• If the loan was made solely in connection with the performance of services, it may be treated as compensation even when the employee owns a substantial amount of stock.