Using Loans to Extract Cash From a Closely Held Corporation (C-Corp)
In this edition, we will explore the topic of using loans to extract cash from a closely held corporation.
This strategy allows shareholders to access funds without incurring the double-tax consequences associated with dividends.
However, it is important to establish the loan as a bona fide transaction to avoid potential issues.
Determining a Bona Fide Loan
To differentiate between loans and distributions, the intention of both the shareholder and the corporation at the time of withdrawal is crucial.
A shareholder’s declaration alone is not sufficient to classify a withdrawal as a loan. Several factors can help determine if an advance should be treated as a loan or a dividend:
- Extent of shareholder control: If a shareholder has unlimited control over the corporation, loans are less likely to be arm’s-length transactions, increasing the potential for disguised constructive dividends.
- Earnings and dividend history: A corporation’s history of not paying dividends, despite having sufficient earnings and profits, may indicate that loans to shareholders should be considered constructive dividends.
- Magnitude of advances and existence of a ceiling: The absence of a ceiling limiting the amount a shareholder can withdraw from the corporation suggests a constructive dividend. Sizeable advances relative to corporate profits or shareholder salaries can also indicate a distribution rather than a loan.
- Recording advances on books and records: Recording distributions as shareholder loans on the corporation’s books or the shareholder’s personal financial statements provides some evidence that they are loans. However, additional evidence is necessary to substantiate the existence of a bona fide loan.
- Execution of notes: While a formal note is evidence of a shareholder distribution being a loan, the absence of a note does not automatically disqualify it as a loan. The true substance of the transaction carries more weight.
- Payment or accrual of interest: Failure to charge interest on shareholder loans typically indicates a lack of true debt arrangement. However, non-interest-bearing notes may be intended in closely held corporations, subject to the below-market interest rules of Sec. 7872.
- Presence or absence of collateral: Collateral or security strongly suggests a shareholder loan, but the lack thereof has not been a major factor in court decisions. Bylaws stating that shareholder loans are secured by the shareholder’s stock in the corporation can be considered.
- Existence of a set maturity date: A fixed maturity date for a shareholder loan indicates a genuine loan. However, regular renewals without payment and interest charges added to the note balance may diminish the significance of maturity dates.
- Enforcement of repayment by the corporation: If a corporation enforces repayment, it indicates a true debt arrangement. However, this factor is unlikely to be present in controlled corporations.
- Shareholder’s ability and attempt to repay: A shareholder’s financial capacity to repay advances suggests the existence of a true debt. On the other hand, the inability to repay indicates the absence of a genuine loan. A good credit rating carries little weight if repayment is never requested.
- Repayment attempts by the shareholder: Repayment of corporate advances is an indication of a debt relationship, but it must be bona fide. Occasional repayments or applying other corporate payments to the loan balance while it continues to grow may not sufficiently establish a bona fide loan.
- Proportionality to stock ownership: Advances proportional to stock ownership, without other indications of a bona fide debt arrangement, may be deemed constructive dividends, particularly when intended to avoid taxes.
To ensure that amounts owed to the corporation by its shareholder(s) are recognized as bona fide loans, it is advisable for the corporation and shareholder(s) to sign a written note with commercially reasonable terms.
The corporation should pass a resolution authorizing the advances, and the loans should be documented in the corporate minutes.
Adequate recording, repayment schedules, maturity dates, and limits on advances are essential.
The interest rate on the notes should not be lower than the short-term applicable federal rate (AFR) on the date of the note, or the blended AFR for demand loans outstanding for the entire year.
Dividends to Repay Shareholder Loans
Issuing dividends to repay loans to shareholders can be advantageous due to the lower tax rates on dividend income.
However, it is important to ensure that the loan was not initially classified as a dividend by the IRS.
Dividends should be paid proportionally based on ownership interest, which can pose challenges when multiple shareholders are involved and loans are not proportional to ownership.
Furthermore, a 3.8% net investment income tax may apply to qualified dividends for higher-income individuals, resulting in a higher overall tax rate.
Borrowing from Retirement Plans
If shareholders or employees are unable or unwilling to borrow from the corporation, utilizing funds accumulated within a qualified retirement plan can be a viable alternative.
Limited borrowing is permitted from corporate qualified retirement plans, including 401(k) plans, as long as certain requirements are met.
Loans between a participant and a retirement plan are generally prohibited transactions.
However, an exemption exists for loans to participants that meet specific criteria, such as availability to all plan participants on a reasonably equivalent basis, adherence to loan provisions in the plan, and reasonable interest rates and adequate security.
The loan agreement must be legally enforceable, specifying the loan amount, term, and repayment schedule.
Although it must be in writing, a signature is not required if enforceable under applicable law.
Borrowings are typically limited to 50% of the participant’s account balance, up to a maximum of $50,000, and must be repaid within five years.
Hardship withdrawals from 401(k) plans may also be possible in certain circumstances, although they are subject to a 10% penalty tax for withdrawals before age 59½.
In case the borrower leaves the company before repaying the loan, the remaining balance is treated as a distribution subject to income tax and potential penalties. Repayment of the loan before leaving the company is a recommended solution if financially feasible.
We hope this newsletter provided valuable insights into using loans to extract cash from closely held corporations.
Properly establishing loans as bona fide transactions and considering the tax implications of dividends and retirement plan borrowings are essential steps for shareholders and corporations to navigate this strategy successfully.
Thank you for reading, and we look forward to bringing you more informative content in future editions.
Moshe Mindick, CPA