Shareholder Loans

Often it comes to our attention that a shareholder has made or is about to make a loan to his or her closely held corporation. There are number of good reasons to loan money to your corporation rather than invest in additional equity. For instance --

-- Interest paid on debt is deductible by the corporation, but dividends on stock are not.

-- An accumulation of earnings and profits to pay off debt is considered "reasonable" by the Internal Revenue Service, but an accumulation to buy back stock is not (except under special circumstances), and thus makes the corporation potentially liable for an accumulated earnings tax.

-- If your corporation is an "S" corporation, issuing a second class of stock (in order to pay dividends to you, for instance, that would not be paid to other shareholders) is prohibited.

So lending money to your corporation may be the most economical and practical way for the corporation to obtain necessary financing. However, shareholder loans contain a number of traps for the unwary. If there is more than one shareholder, then California law, and the laws of other states generally, require that the loan be approved by a majority of the shareholders other than the lending shareholder; and if the corporation's bylaws require more than majority approval, then the required super-majority approval must be obtained.

In order to establish conclusively that the required approvals of disinterested shareholders and directors have been obtained, the shareholders and the board of directors, by the proper votes, should adopt resolutions establishing the need for funds, stating how the funds will be used, and approving the loan. This may be accomplished by meetings for which proper notice is given in accordance with applicable law and the bylaws of the corporation, or by actions taken by unanimous written consent.

Even if there is only one shareholder, the proper resolutions should be adopted in order to maintain the formal separation between the corporation and its shareholder. Taking these formal actions will help avoid the possibility that the lender/shareholder will be held liable for the corporation's obligations. It may also aid, in certain circumstances, in preventing an outside creditor from claiming an interest in cash or other property distributed by the corporation to the shareholder.

The other major trap has been well laid by the Internal Revenue Service. The IRS and the courts have developed a number of rules to determine whether shareholder funds used by the corporation constitute corporate debt or shareholder equity. These rules are applied in a number of different situations involving claims by the IRS for unpaid taxes. Unfortunately, there is no "bright-line" differentiation between debt and equity; all of the facts in each case must be taken into account. The IRS proposed, but later withdrew, regulations that would have made it easier to know in advance whether shareholder funds in any particular case constituted debt or equity. However, there are a number of characteristics that any debt should have to avoid it being re-characterized as equity for tax purposes. These are:

-- a fixed maturity date that is not too far in the future

-- an unconditional obligation to pay interest at fixed times, as well as principal

-- interest at or near a market rate

-- transferability; that is, allowing the shareholder to sell or assign the loan to a third party

-- no subordination of the loan to other creditors

-- security for the debt

-- remedies on default (including items such as a higher, but not usurious, interest rate on defaulted amounts, payment of attorneys' fees, foreclosure on security)

-- use of a written instrument such as a promissory note

-- indebtedness disproportionate to shareholdings (for instance, two 60/40 shareholders should not lend money on a 60/40 basis to their corporation)

Although all of the above factors are relevant, no single factor will be crucial. The ultimate question is whether an outsider would have provided funds to the corporation on the same terms as the shareholder. A recent Tax Court case, C. Kadlec, decided in April 1996, illustrates the way the courts approach the issue. In that case, a shareholder made advances to his corporation in a series of "loans" which were never repaid. Ultimately, the corporation's board of directors determined that the shareholder's promissory notes were worthless; the shareholder then claimed a bad debt deduction.

The IRS claimed that the loans were actually capital contributions and disallowed the bad debt deduction. The court pointed out the following facts -- (1) no interest was ever paid; (2) the shareholder expected repayment out of corporate profits only, not in any or all events; (3) the corporation had very little equity in proportion to its total debt; and (4) the shareholder's loans were subordinated to other corporate debts. No outside person would, in the court's opinion, have made a loan under these circumstances, so the advances had to be considered capital contributions and no bad debt deduction could be taken.

We hope this information provides help in your decisions about funding your corporate affairs. Bowles & Verna will be happy to help in analyzing the implications of your shareholder loans, and in properly documenting transactions so that you accomplish your intentions. Feel free to contact us at any time.

Charles S. Goldman advises clients in a wide variety of transactional matters and directs Business Vision, Bowles & Verna's innovative legal facilitation service for business deals. To contact Mr. Goldman by email, click here.