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.