Make Tax-Wise Loans to Your Business
When it comes to pumping new money into your business, there's often a right way and a wrong way. Generally, you will want to do the deal in the form of a loan. Here are some tips on getting the biggest tax-saving bang for the bucks you inject into your corporation or LLC. - Regular corporations.
If your business is operated as a regular corporation, make a loan instead of a contribution of additional capital. Why? Because you cannot later withdraw part of your equity investment without worrying about adverse tax consequences. Most successful operations will have current or accumulated earnings and profits. That means dividend treatment will apply to all or part of any funds you want to take out of the corporation in the future. This is a poor tax result because dividends are taxable income to you, and your corporation gets no deductions. In contrast, if you lend the money to the corporation, you can be repaid with interest without tax problems. The loan principal payments are tax free. And the interest is tax deductible to the corporation, which puts additional cash in your hands without double taxation.
What if the bank is willing to make a loan directly to you, but not to your corporation? No problem. Simply make a 'back-to-back" loan to your corporation at the same interest rate. Don't use the borrowed funds to make a capital contribution. Then you'll be forced to make dividend payments to repay your loan from the bank. - S Corporations and LLC's.
If your business is an S corporation or LLC, you generally can withdraw your equity tax free (up to the basis in your ownership interest). This means there's not the critical distinction between equity and debt as there is for regular corporations.
However, you may still want to use loans as part of your capital structure. For example, you could secure the loan made to the S corporation and thereby become a secured creditor of the corporation. Also, if the business needs money and only one owner has available cash, he can make a loan to the equity without altering the equity ownership percentages.
Example: Tom and Jerry form a 50/50 real estate development partnership. They each contribute $100,000 to get the deal off the ground. Later, the partnership has the chance to buy a piece of property for the bargain price of $100,000. Tom has plenty of cash, but Jerry has none and the commercial loan market has dried up. In this scenario, the 50/50 equity sharing arrangement can be preserved by arranging for Tom to loan the partnership the $100,000 needed Lenders Agreement and Promissory Note for the property acquisition. The same basic principle applies to S corporations and LLC's (and regular corporations) with several shareholders. - Back-to-Back Loans A Must for S Corporations.
For loss deduction purposes, S corporation shareholders are limited to the basis in their stock plus the amount of any loans made by them directly to the corporation. However, shareholders get no basis from debt inside the S corporation, even if it's all personally guaranteed.
Fortunately, it's relatively easy to sidestep this problem. If the lender demands personal guarantees, simply have the loans made to the shareholders rather than the corporation. The shareholders can then make back-to-back loans to the corporation and get the additional tax basis. Economically, the lender and the shareholders are in exactly the same position as if a corporate loan were guaranteed. But, the tax results are much better with a back-to-back loan.
When an S corporation receives shareholder loans, you want to make sure the IRS can't characterize the loans as equity. If that happens, you run the risk of having a second class of stock, which will invalidate your S election. The easiest way to avoid potential problems is to meet the so-called straight debt guidelines issued by the IRS. Debt must meet four requirements to qualify for this straight debt safe harbor:
1. It must be a written unconditional obligation to pay a sum certain on demand or on a specified due date.
2. The interest rate and payment dates must not be contingent on profits, the corporation's discretion or similar factors.
3. It cannot be directly or indirectly convertible into stock or any other equity interest in the corporation.
4. It must be owed to an individual, estate, trust or tax-exempt entity that is an eligible S corporation shareholder. |
