If you own a closely held corporation, you have the option to borrow funds from your business at rates lower than those offered by banks. However, it's crucial to mitigate risks and ensure an appropriate interest rate is charged.
Basics of this strategy
Interest rates have risen in recent years. Consequently, shareholders might opt to borrow from their corporations instead of facing higher rates from banks. Generally, the IRS requires closely held corporations to apply interest on related-party loans, including those to shareholders, at rates that meet or exceed applicable federal rates (AFRs). Failing to do so could result in adverse tax consequences. Fortunately, AFRs are typically lower than rates offered by commercial lenders.
It can be advantageous to borrow money from your closely held corporation to pay personal expenses. These expenses may include your child’s college tuition, home improvements, a new car or high-interest credit card debt. But avoid these two key risks:
1. Not creating a legitimate loan. When borrowing money from your corporation, it’s important to establish a bona fide borrower-lender relationship. Otherwise, the IRS could reclassify the loan proceeds as additional compensation. This reclassification would result in an income tax bill for you and payroll tax for you and your corporation. (However, the business would be allowed to deduct the amount treated as compensation and the corporation’s share of related payroll taxes.)
Alternatively, the IRS might claim that you received a taxable dividend if your company is a C corporation. That would trigger taxable income for you with no offsetting deduction for your business.
Draft a formal written loan agreement that establishes your unconditional promise to repay the corporation a fixed amount under an installment repayment schedule or on demand by the corporation. Take other steps such as documenting the terms of the loan in your corporate minutes.
2. Not charging adequate interest. The minimum interest rate your business should charge to avoid triggering the complicated and generally unfavorable “below-market loan rules” is the IRS-approved AFR. (There’s an exception to the below-market loan rules if the aggregate loans from a corporation to a shareholder are $10,000 or less.)
Current AFRs
The IRS publishes AFRs monthly based on market conditions. For loans made in July 2024, the AFRs are:
- 4.95% for short-term loans of up to three years,
- 4.40% for mid-term loans of more than three years but not more than nine years, and
- 4.52% for long-term loans of over nine years.
These annual rates assume monthly compounding of interest. The AFR that applies to a loan depends on whether it’s a demand or term loan. The distinction is important. A demand loan is payable in full at any time upon notice and demand by the corporation. A term loan is any borrowing arrangement that isn’t a demand loan. The AFR for a term loan depends on the term of the loan, and the same rate applies for the entire term.
An example
Suppose you borrow $100,000 from your corporation with the principal to be repaid in installments over 10 years. This is a term loan of over nine years, so the AFR in July would be 4.52% compounded monthly for 10 years. The corporation must report the loan interest as taxable income.
On the other hand, if the loan document gives your corporation the right to demand full repayment at any time, it’s a demand loan. Then, the AFR is based on a blended average of monthly short-term AFRs for the year. If rates go up, you must pay more interest to stay clear of the below-market loan rules. If rates go down, you’ll pay a lower interest rate.
Term loans for more than nine years are smarter from a tax perspective than short-term or demand loans because they lock in current AFRs. If rates drop, a high-rate term loan can be repaid early and your corporation can enter into a new loan agreement at a lower rate.
Avoid adverse consequences
Shareholder loans can be complex, particularly if the loan charges interest below the AFR, payments cease, or there are multiple shareholders in the corporation. Consult an advisor at Axley & Rode for guidance tailored to your circumstances.
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