A Shareholder Loan: Understanding and Avoiding the Trouble
LOANING YOURSELF MONEY FROM THE PRACTICE IS TRICKY
Shareholder loans are generally created in two circumstances:
Occasionally, a practice owner may borrow a significant amount of money from the practice to make a large personal purchase with the intent of paying the amount back in the future. This is different than taking money out of the practice as a distribution with no intention of repayment.
More commonly, a practice owner will take a distribution in excess of the tax stock basis. Since the practice owner has less basis in the practice than the distribution, a shareholder loan is created instead of paying taxes on those distributions in excess.
The IRS reviews these transactions closely to determine whether this transaction is truly a loan or actually compensation. A reclassification of the transaction by the IRS will result in additional taxes and penalties.
Since there is no bright line test or safe harbor election related to shareholder loans, each consideration is based on the facts and circumstances of each loan. To ensure that your shareholder loan is less likely to be reclassified by the IRS, you can look at the six factors that the US Tax Court uses to determine if a shareholder loan is legitimate:
The size of the loan. If the loan is less than $10,000 it does not require interest to be charged. If it is over $10,000, it MUST charge an “adequate” rate of interest, as determined by the IRS Applicable Federal Rates (AFRs).
The practice’s earnings and distribution history. Is the practice paying you a reasonable wage and did you take regular distributions based on practice profitability before taking an additional loan?
Provisions in the shareholders’ agreement. Even though most practices are owned by just one or two shareholders, they are still subject to corporate law and CANNOT just be treated as your own personal funds.
Loan agreement and repayment history. Have you executed a formal, written note at the time of the loan that specifies all of the repayment terms? It needs to be an “arm’s length” loan contract with an interest rate, maturity date, collateral pledge and repayment schedule. It should be treated as any other equipment or bank loan.
The ability to repay the loan. Did the practice loan you $500,000 on a 5 year note when you only have a W-2 that pays you $150,000? This situation is often considered an attempt to hide taxable compensation.
Level of control over the practice decision making. Are you the sole shareholder making a loan to yourself without any oversight? This lack of corporate governance will get the attention of the IRS.
PLANNING RELATED TO SHAREHOLDER LOANS
Here are the best ways to deal with shareholder loans and avoid the tax and financial issues that they cause:
Do not mess with shareholder loans. Pay yourself a reasonable wage and take distributions that do not exceed your basis. This is trickier in the early years of your practice where you have very low basis, so you may need to hold off living that “dentist life” until debt is paid down and your basis has increased.
Keep the loan under $10,000. Under this amount, you are not required to charge interest and IRS scrutiny is reduced simply based on the size of the loan.
Create a loan agreement. It should look very similar to one you would sign with the bank, in that it includes an interest rate, maturity date and collateral.
AS ALWAYS, THE SUMMARY ABOVE IS GENERAL IN NATURE AND NOT INTENDED AS SPECIFIC TAX ADVICE FOR THE READER.
PLEASE CONSULT WITH YOUR TAX ADVISOR TO DEVELOP A PLAN THAT BEST SUITS YOUR NEEDS.