The recent pandemic put many small businesses in a tough position with more cash flowing out of the bank than in. Many business owners resorted to funding provided by shareholders, creating a whole new set of tax implications.
Shareholder Loans vs Capital Contributions
There are two ways to record additional funds given by partners in an S-corp: shareholder loans and capital contributions. A shareholder loan goes on the books as a payable while simultaneously increasing the shareholder’s loan basis. On the other hand, a capital contribution goes directly to equity and increases the shareholder’s stock basis. There are two primary types of basis: stock and debt.
Why is basis important? Losses are only able to be taken when there is sufficient basis. In addition, the higher the basis a shareholder retains, the less of a gain the individual will need to report when disposing of their S-corp stock. Finally, the basis determines which dividends are taxable and nontaxable.
Non-dividend distributions are considered nontaxable up until the amount of stock basis a shareholder has in the company. Any distributions in excess of the stock basis are then taxable to the shareholder. In some instances, a shareholder will loan money to the S-corp so that the S-corp can make a taxable distribution that will offset any other losses the company incurred. Losses directly decrease the debt basis a shareholder retains, while distributions do not factor into the debt basis.
The stock basis of a shareholder includes all income, loss, deductions, and distributions throughout the timeline they have held the stock. Capital contributions increase this basis. Sometimes shareholders will choose to make a capital contribution to take advantage of suspended losses or reclass a portion of the distribution as nontaxable.
Further Understanding Basis
Going through an example of a business loan can help you understand the basics. Let’s say that a shareholder currently has a $2,000 stock basis and chooses to make a capital contribution of $2,000. This contribution will increase the stock basis to $4,000, resulting in the ability to either:
· Pass through up to $4,000 of losses
· Receive a nontaxable return of capital of $4,000
If losses occur in the same tax year that exceeds the stock basis, the shareholder may be able to offset future gains by carrying forward the loss. However, if the shareholder loans the company money instead of making a capital contribution, the shareholder now has two different basis amounts: $2,000 would be considered a stock basis while the other $2,000 is considered a debt basis.
If the company incurs a loss in the current year that brings the stock basis to zero, any current or future losses and deductions will then be applied to the stock basis. For example, if there was a loss of $3,000, $2,000 would reduce the stock basis and the other $1,000 would reduce the debt basis until both are zero.
Choosing the Right Method
If the business is waiting on financing to go through, shareholders may choose to loan the company money. This is because the business is expected to pay them back in the near future and can avoid making a distribution to all shareholders. The IRS requires pro rata distributions, meaning if the company makes a distribution to one shareholder, the other shareholders must also receive a proportionate distribution. This can create issues for shareholders who make a contribution and want to be paid back.
Additionally, you must also analyze if interest will be assessed on shareholder loans. The IRS requires businesses to charge an adequate interest rate, which is usually the market rate, on loans over $10,000. With rising interest rates, these amounts can begin to add up for the company while increasing the shareholder’s taxable income.
The Importance of a Debt Agreement for Shareholder Loans
Due to the pass-through tax benefits shareholder loans offer, the IRS closely monitors S-corps to ensure they aren’t avoiding payroll and income taxes. When a shareholder contributes to the S-corp in the form of a loan, the shareholder receives the same assets protection as third-party lenders. However, to classify the contribution as a loan and enjoy the tax benefits, the IRS code 385 (b) explains factors taken into account a bona fide debt agreement between the S-corp and the shareholder.
Choosing the right method can be a tough decision, especially with both having advantages and disadvantages. Talking through the decision-making process with an expert, like Abdul Tax Consulting and Accounting Services, is a great way to find the right solution. For more information, reach out today.