If you were to loan me $20k today, would you insist on loan documents, regular payments, and interest? Of course you would! Such requirements and documentation would seem to be common sense, so why do many shareholders fail treat the loans to their S-Corporations the same way?
An S-Corporation is a separate legal entity, and any transactions between shareholder and the corporation have to be treated as such. Any funds contributed by the shareholder are either capital contributions or loans from the shareholder. If the corporation pays personal expenses for the convenience of the shareholder, the payment has to be reclassified as a loan from shareholder repayment or a distribution. There needs to be a very clear distinction between shareholder and corporation with these transactions and the documentation should be the same as if the transactions were with an unrelated third-party.
In my experience, I have seen this issue come up in IRS audits and with bank loan renewals and applications – especially with S-Corporations owned by a single shareholder. Without other shareholders to help keep things formal and a clear separation between business expenses and shareholder personal expenses, the single shareholder can get lazy and end up using their S-Corporation like a personal checking account. If matched with very poor documentation, this can lead to big problems with the IRS – even loss of the S-election status in serious cases.
How can you avoid these problems and make sure you are properly documenting your shareholder loans? Here are my suggestions based on my experiences with small S-Corporations:
- Keep your personal expenditures and transactions out of the S-Corporation. It is a separate legal entity and there is no reason for co-mingling personal and business transactions except for the occasional payment for the convenience of the shareholder.
- Reimburse any expenses paid personally on a regular basis via an signed expense report. Attach receipts and document the who, where, what, and why for meals and entertainment, travel, and other expenses that need explanation as to the business purpose.
- Avoid using personal credit cards for the business; however, if you must resort to this, try to use the card(s) exclusively for business and then use other personal credit cards for personal transactions.
- If you loan funds to the S-Corporation, keep a record of the loan and try to have the corporation make regularly scheduled repayments. If the loan exceeds $10k, the corporation needs to start tracking and paying interest on the loan principal.
- Talk with your CPA and make sure you understand any reclassification entries made to loans from shareholder accounts.
- Use a lawyer that specializes in small business that will prepare demand notes and documentation for the loan from shareholder on a regular basis. Many small S-Corporations try to cut corners in this area and it can really hurt them down the line.
- Document, document, document! I know life is busy and small businesses require more time than you have, but do not get behind on this or create excuses for yourself. If you cannot meet documentation requirements, then you should not be incorporated.
I read your article with much interest. I am a single shareholder of an S Corporation. I document everything. But I am curious about the loans. When I incorporated I brought in 193k of inventory, receivables, and cash to the Corporation. The CPA said that I just needed to create a liability account for this. Didn’t sound right to me but that’s what I did. A year later I went to another CPA and got the same information. Now, I logged that 193k in as a loan. The Corporation paid it all back and I (shareholder) loaned it back again. All the while documenting everything. The only thing is, in my loan papers I showed a 5% interest rate but when it came time to pay it, I just waived the interest.
What is the correct way to handle this and straighten it out on my books, if necessary?
Thank you.
Dave
Actually, on loans FROM shareholder, it is very common for CPAs waive the interest altogether. I have done it myself many times, but ultimately it depends on the circumstances. If I know a client has a very good lawyer, I will put interest on the loan because most lawyers are going to want interest on it when they put together the annual documentation for the client.
Technically, we should be putting interest on all shareholder loans over $10K like I suggest in this article. By doing this, I believe you are fully protecting yourself from it becoming an audit concern. It is true that the IRS often does not press the loan from shareholder interest issue; however, I always try to minimize the number of audit issues, and accruing interest on a shareholder loan is a fairly easy way to do this.
If it was a loan TO shareholder, we would have a different scenario. Interest should always be charged or accrued on loans to shareholders over $10k.
In your situation, I do not think you really need to make any corrections; however, there is one item of concern with regard to your initial contribution to the corporation. Technically, when you contributed non-cash items into the corporation (A/R and inventory), it should have been offset against “Additional Paid-In Capital” rather than the loan from shareholder. However, it is probably a moot point now as I am assuming it has been a few years since incorporation. It just means that your corporation is much more thinly capitalized then it should have been. It is not the end of the world, but it is a good thing you are no longer using that first CPA.
I hope that helps.
Hi,
I am in business with 3 others, s corp, we all own 25%. The corporation paid for a mortgage on a house that was initially going to be used to expand the business, however it became living quarters for our father. I took my name off the house several years ago( due to illegal activities) & asked that the house be pd for personally, not through the biz. This did not happen. The house was just sold & the other shareholders pocketed the cash. I thought it should be returned to the corp. At first our accountant said it needed to be returned to the corp, but then changed her mind. Is this legal? I am very concerned. Thanks, Mieka
It all depends on how the items were treated on the prior returns. If the corporation was making the mortgage payments and the tax preparer was posting them as distributions to the shareholder (personal transaction reclassification), then the funds would not need to go back to the corporation. Hopefully that is the case, otherwise your concerns are valid.
Did the corporation own and depreciate the house?
Hopefully this is not the case. Appreciating property should NEVER be put in a corporation – reason being that any transfer to a shareholder would create a taxable event since it has to be transferred at fair market value. Then if there is a gain on the property, you would have recaptured depreciation as well. Not a good scenario…
There is also the personal tax aspect. Hopefully someone was able to show that they owned and used the house as their primarily residence for two out of the last five years.
Sounds like quite a complex situation. If you were really concerned about it, you could meet with a CPA that is independent of the other shareholders; however, the CPA would need copies of the tax returns, financial statements, and any workpapers available in able to give you good answers.
You might also want to seriously think about selling your shares in the company. Multi-owner businesses are like marriages, and you business doesn’t sound like a healthy marriage.
Hello,
I am doing ap/ar for a lady who runs an S Corp.
She uses her BUSINESS credit card for personal use. I told her to stop doing this for one.
However, the old accountant that used to do this set up an account “Shareholder Loan” as a LTL for these personal uses to go to.
This doesnt seem right. The owner of the business isnt planning to pay these items back. The owner also does not take a salary.
1. What should these personal items be put to? What type of account? (this is done in QB).
Thanks,
Lisa
Personal expenditures are non-deductible and therefore should be classified as distributions (which is an equity account). However, it sounds like the shareholder had a loan from shareholder balance, so rather than classifying the personal transactions as distributions, the accountant was simply reclassifying the personal transactions as loan from shareholder repayments. Once this loan balance is fully repaid, then they would have to be distributions.
Whether a personal expenditure is a distribution or loan from shareholder repayment is a tax return presentation issue, so for QB – I would just use distributions for all personal transactions. The items do not necessarily need to be paid back.
The bigger issue is the salary. You might let the owner know that S-Corporation shareholder have to take a reasonable wage, and a zero wage is a big red flag to the IRS and an easy audit adjustment for them. She should check out my post on S-Corp reasonable wage.
Can personal credit cards used by an S-Corp shareholder for business expenses be treated as a loan from stockholder thus creating basis that will allow the stockholder to deduct losses? How do you recommend recording this type of activity?
Yes, but you have to careful with debt basis. It is important that the shareholder experience an actual economic outlay to acquire the basis (see Rev. Rul. 81-187). In english – the credit card should be solely in the shareholder’s name and the shareholder should be making the actual payments (not the corporation). This means when expenses paid with the credit card that they are booked as loans from the shareholder, and then the corporation repays the shareholder on the loan when the shareholder needs to make a credit card payment. Guarantees by the shareholder do not work – must be in shareholders name only.
Also, making yourself a co-maker on a corporate loan does not work either. You have to be very careful if you are trying to “restructure” loans to get basis as there are a lot of court cases in the IRS’s favor in this area.
I have used this before for a shareholder and it does work well that first year that the credit card balance is reclassified; however, usually it is with clients that have poor records and later told me the credit card was personal. Had they originally provided good records with actual credit card statements, I would have known that the credit card accounts were personal and I would have already used that basis against losses.
Hope that helps.
On my 2007 tax return, my accountant did not place loan to shareholder on the return…..In QB, it is recorded loan to shareholder and when I receive distributions from the company, it offset my loan to the company…..
In 2008, I moved and had another accountant who stated I needed to place loan to shareholder amount on the tax return?
Which is correct? And how is the distributions amounts figured out on the return?
It is likely that the loan to shareholder was reclassified as most accountants would not simply leave a balance off the return as Schedule L, M-1, and M-2 would not balance.
Here is how distributions work when you have a loan to shareholder…
Distributions can be taken from the current year earnings or from retained earnings, so your maximum limit each year is the net income and any remaining retained earnings from the prior year. When your distributions exceed these amounts, a loan to shareholder account results. The loan to shareholder can only be reduced by repayments by the shareholder or reclassifying them as distributions when the limits allow. Most CPAs and accountants try to clear the loan to shareholder balance to distributions whenever there is net income and “room” for the reclassification. It sounds like this what happen in your case. The way you check that is to compare distributions in QuickBooks to the distributions on the return. The difference is likely the balance you are looking for.
The other possibility is that it was offset against a loan from shareholder account. If it is actually error, then you have bigger problems and will likely need to amend depending on the circumstances.
One final note, it sounds like the bigger problem is that you are not getting adjusting entries from your accountants. The QuickBooks accoutants copy makes this very easy, so accountants should have no excuse. Make sure you get the journal entries so that your QuickBooks file matches the tax return, which will also let you see what they changed. If you don’t understand an adjustment, make sure you ask.
You wrote: “It is likely that the loan to shareholder was reclassified”. Let’s reverse that and say it was a shareholder loan to corporation. If on the 2007 return it was on the balance sheet as a “shareholder loan to” and on the 2008 return it was reclassified as something else like “Additional Capital Contribution” for example, would that loan need to be recorded as a loan paid back and show up as a distribution (on K1) or is just reclassifying good enough?
Thanks.
Dave
It is a little rare to reclassify a loan from shareholder (to the corporation) to additional paid-in capital since those funds become part of the permanent capital stock of the corporation; however, there might have been concern that the corporation was too thinly capitalized. I prefer not to do this as it can cause problems later if the shareholder(s) take too much in distributions.
The reclassification would be good enough as far as documentation goes. It would not show up on the K-1.
If you placed property into the S-corp as a shareholder loan to the S-corp, can you remove property from S-corp as repayment of that loan to shareholder? This shareholder owns 100%. And how do you value the property? Cost basis or current market value?
What if you never placed property into S-corp only cash? Can you still take property as repayment?
Actually, loans can only be cash. When you contribute property to a corporation it is valued at fair market value (or net book value if depreciated in a sole proprietorship or another entity) and becomes additional paid-in capital.
Any time you take property out of a corporation, it has to come out at fair market value, and it is effective “sold” to the shareholder.
This why you should never put appreciable property in a corporation.