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10 • 2016

Loans to Shareholders Must Be Made on Market Terms

In small, closely held corporations owned by one or just a few shareholders, the corporation will often make loans to a shareholder. Such loans are perfectly legal, but they must be made on market terms. That is, a corporation cannot lend money to a shareholder with no interest whatsoever and no regular payment obligation and expect that the transaction will still be respected by the Internal Revenue Service.

A number of factors are considered in determining whether a transaction between a corporation and a shareholder was really a bona fide loan, including whether: the shareholder gave security for the loan; the shareholder gave a promissory note to evidence the loan; there was a set maturity date in the note; there was a repayment schedule or an attempt to repay by the shareholder; and the corporation took any action to obtain repayment of the loan.[1] In other words, the transaction has to look, and be structured, like a real loan in order to be treated as such.

Another especially important factor in making that determination is whether the corporation charges interest on the loan. This issue is significant enough that it has been codified in the Internal Revenue Code.[2] Under section 7872 of the IRC, if a corporation lends money to a shareholder with no interest or at an interest rate that is below market, then the corporation is treated as having transferred to the shareholder, and the shareholder is treated as having repaid to the corporation, an amount equal to the foregone interest, thereby subjecting the corporation to tax liability on the foregone interest.[3] The IRS can impute interest in this manner under section 7872 on “any” below-market loan made by the corporation, whether the loan is made to a majority or a minority shareholder.[4]

The determination of what is a “below-market loan,” and the amount of “foregone interest” imputed to a corporation that has made a below-market loan, is made by reference to the “applicable Federal rate,” or AFR, as of the day on which the loan was made.[5] The AFR is determined by the Secretary of the Treasury on a monthly basis[6] and then published as a revenue ruling.[7] If the corporation makes a loan to one of its shareholders below the AFR for the month in which the loan is made, then it is a below-market loan subject to the rules for imputing interest under section 7872 of the IRC.

The lesson here is a simple one. Corporations can make loans to shareholders, but they must do so on market terms. In particular, the loan must accrue interest at no less than the AFR for the month in which the loan is made. Obviously, other standard terms should also apply, including the obligation to make regular payments and eventually pay off the loan entirely. It simply will not do to make a loan to a shareholder with no interest and no evidence that the parties ever intended for the loan to be paid back to the corporation.

[1]These factors and more are set out in a guide on audit techniques addressing issues regarding loans to shareholders prepared by the Internal Revenue Service. See Internal Revenue Service, Shareholder Loan Audit Techniques Guide, 2001 WL 1763433, at *2-5 (June 2001), available at http://www.unclefed.com/SurviveIRS/MSSP/a8shloan.pdf.

[2]See 26 U.S.C. § 7872.

[3]See id. § 7872(a)(1); KTA-Tator, Inc. v. Comm’r, 108 T.C. 100, 106 (1997).

[4]See 26 U.S.C. § 7872(c)(1)(C); Rountree Cotton Co. v. Comm’r, 113 T.C. 422, 432 (1999), aff’d, 12 F. App’x 641 (10th Cir. 2001).

[5]See 26 U.S.C. § 7872(e)(1)(A), (2)(A), (f)(2).

[6]See id. § 1274(d).

[7]See Internal Revenue Service, Index of Applicable Federal Rates (AFR) Rulings, available at https://apps.irs.gov/app/picklist/list/federalRates.html (last visited June 9, 2016).