Did you know that you can borrow funds from your own closely held corporation at rates much lower than those charged by a bank? This strategy can be advantageous in some aspects but careful planning is crucial to avoid certain risks.
The Basics
Interest rates have risen sharply over the last couple of years, making this strategy more attractive. Rather than pay a higher interest rate on a bank loan, shareholders can opt to take loans from their corporations.
This option—with its lower interest rates—is available thanks to the IRS’s Applicable Federal Rates (AFRs) which are typically more budget-friendly than rates offered by banks. If the charged interest falls short of the AFRs, adverse tax results can be triggered.
This borrowed money can be used for a variety of personal expenses, from helping your child with college tuition to tackling home improvement projects or paying off high-interest credit card debt.
Two Traps to Avoid
1. Not creating a genuine loan
The IRS needs to see a clear-cut borrower-lender relationship. If your loan structure is sloppy, the IRS could reclassify the proceeds as additional compensation, which would result in an income tax bill for you and payroll tax for you and your corporation. However, the business would still be able to deduct the amount treated as compensation as well as the corporation’s share of related payroll taxes.
On the other hand, the IRS can claim that you received a taxable dividend if your company is a C corporation, triggering taxable income for you with no offsetting deduction for your business.
It’s best to create a formal written loan agreement to establish your promise of repayment to the corporation either as a fixed amount under an installment schedule or on demand by the corporation. Be sure to document the terms of the loan in your corporate minutes as well.
2. Not charging sufficient interest
To avoid getting caught in the IRS’s “below-market loan rules” make sure you’re charging an interest rate that meets or exceeds the AFR for your loan term. One exception to the below-market loan rules is if aggregate loans from corporation to shareholder equal $10,000 or less.
Current AFRs
The IRS publishes AFRs monthly based on current 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 rates assume monthly compounding of interest. However, the specific AFR depends on whether it’s a demand loan or a term loan. Here’s the key difference:
- Demand loans allow your corporation to request repayment in full at any time with proper notice.
- Term loans have a fixed repayment schedule and interest rate set at the loan’s origination based on the AFR for the chosen term (short, mid, or long). This type of loan offers stability and predictability to both the borrower and the corporation.
Corporate Borrowing in Action
Imagine you borrow $100,000 from your corporation to be repaid in installments over 10 years. Right now, in July 2024, the long-term AFR is 4.52% compounded monthly over the term. To avoid tax issues, your corporation would charge you this rate and report the interest income.
On the other hand, if the loan document states that the borrowed amount is a demand loan, the AFR is based on a blended average of monthly short-term AFRs for the year. If rates go up, you need to pay more interest to avoid below-market loan rules. And, if rates go down, you pay a lower interest rate.
From a tax perspective, term loans for more than nine years are because they lock in current AFRs. If interest rates drop, you can repay the loan early and secure a new loan at the lower rate.
Avoid adverse consequences
Shareholder loans are complex, especially in situations where the loan charges below-AFR interest, the shareholder stops making payments, or your corporation has more than one shareholder. Contact a Smolin advisor for guidance on how to proceed in your unique circumstance.