By Matt Lipkowitz
When asking an owner of a small business what is the difference between cash contributions and distributions and loans to and from entities the most common answer would be “Aren’t they the same thing? It just depends on how my accountant classifies the transaction.”
This common misconception with majority of individuals who own and operate their own businesses can cause quite a headache when it comes to taxes and the Internal Revenue Service. It is smart tax planning to be informed about all possibilities and tax consequence that may occur as a result of providing capital to your small business. There are both benefits and detriments to the classification and treatment of member/shareholder loans to and from an entity and by understanding these issues it may prove to be a win/win situation for both the owner and the entity.
When creating loans between owners and their entities there are a list of items you want to be sure to include, this will limit the ability for the IRS to question the reasonableness of the loan.
- A loan agreement.
- A fixed payment date and provide adequate stated interest.
- The Interest rate should be at or above the applicable federal rates, which can be found on the IRS website.
- Rights to property as secured collateral.
- Terms that reflect commercial reasonableness – such as waiver of demand, presentation and notice, rights to attorney’s fees.
The items above will help support the facts of a bona fide loan between an entity and its owner. Making it much more difficult for the IRS to reclassify the loan as contributed capital, a cash distribution, or a cash dividend.
These reclassifications can greatly impact the taxable income of the owner of the entity. By reclassify a loan as a cash dividend in a C Corp or S Corp this creates additional dividend income for the shareholder, and is not a deductible expense of a the C Corp or S Corp.
If a loan is reclassified as a cash distribution, this may reduce the owners’ basis below zero, which may disallow and suspend any losses previously taken. This may greatly increase the taxable income on the return of the member creating a much larger tax burden than expected.
Loans reclassified as contributions don’t create as many problems since cash classified as a loan or contributed capital both increase the basis of owner’s interest in their entity. However, it may postpone or limit the repayment of the contributed funds due to cash flow and operating activity of the entity.
So be sure to examine the loans between you and your entities to be confident that they are reasonable and have the items list above to help support the purpose of the loan. As always consult your tax advisor if questions and concerns arise about loans between you and your entity, being overly cautious is always a good way to go.