Borrowing from Your Closely Held Business: Structure the Deal with Precision

If you own a closely held corporation, borrowing funds from your business at rates lower than those charged by banks can be advantageous. However, it is crucial to structure these loans carefully to avoid potential risks and ensure compliance with IRS regulations regarding interest rates.

Interest Rate Dynamics

With the recent increase in interest rates, shareholders may find it financially prudent to take loans from their corporations instead of securing high-interest bank loans. The IRS mandates that closely held corporations charge interest on related-party loans, including loans to shareholders, at rates at least equal to the applicable federal rates (AFRs). Failure to do so can lead to adverse tax consequences. Notably, AFRs are typically lower than commercial lending rates, making this an attractive option.

Borrowing from your closely held corporation can be beneficial for covering personal expenses such as college tuition, home improvements, a new car, or paying off high-interest credit card debt. However, two primary risks must be mitigated:

Establishing a Legitimate Loan

To ensure the loan is legitimate and not reclassified by the IRS as additional compensation (which would result in income tax for you and payroll tax for both you and your corporation), it is imperative to create a bona fide borrower-lender relationship. This can be achieved by drafting a formal written loan agreement that includes:

• An unconditional promise to repay a fixed amount under an installment repayment schedule or on demand by the corporation.
• Documentation of the loan terms in the corporate minutes.

In the case of a C corporation, the IRS might also reclassify the loan as a taxable dividend, resulting in taxable income without an offsetting business deduction.

Charging Adequate Interest

The corporation must charge at least the IRS-approved AFR to avoid the "below-market loan rules," which can have complicated and unfavorable tax implications. An exception exists for loans where the total amount from the corporation to the shareholder is $10,000 or less.

Current AFRs

The IRS publishes AFRs monthly based on market conditions. For loans issued in July 2024, the AFRs are:

• 4.95% for short-term loans (up to three years)
• 4.40% for mid-term loans (over three years but not more than nine years)
• 4.52% for long-term loans (over nine years)

These rates assume monthly compounding of interest. The applicable AFR depends on whether the loan is a demand or term loan:

• A demand loan is payable in full at any time upon notice and demand by the corporation.
• A term loan has a fixed repayment period and its AFR depends on the loan's term, remaining constant throughout the loan duration.

Illustrative Example

Assume you borrow $100,000 from your corporation with a repayment period of 10 years. This constitutes a long-term loan, so the applicable AFR for July is 4.52%, compounded monthly. The corporation must report the interest as taxable income.

Conversely, if the loan agreement allows the corporation to demand full repayment at any time, it qualifies as a demand loan. The interest rate would then be based on a blended average of monthly short-term AFRs for the year, which can fluctuate with market rates.

Strategic Considerations for Loan Term Selection

Long-term loans (over nine years) are typically more advantageous from a tax perspective compared to short-term or demand loans, as they lock in current AFRs. If interest rates decline, a high-rate term loan can be repaid early, and a new loan can be initiated at the lower rate.

Conclusion

Shareholder loans require meticulous planning to avoid adverse tax consequences, especially when interest rates fall below the AFR, payments are missed, or multiple shareholders are involved. For tailored advice on structuring shareholder loans in your specific situation, please contact us.