Watch Out for Unexpected Tax

Stockholders who lend money to their C corporations are expected to charge interest on the loan at the market rate. Those who charge less -- or nothing -- can be taxed as if they charged interest at a rate that is periodically determined by the IRS under federal law.

 

You already know that taxes can be imposed on money taken out of your C corporation. But not all business owners know they can also be taxed on money put into the corporation in the form of a loan.

 

Specifically, the difference between that interest rate and the lesser (or zero) rate actually charged by a stockholder is taxable to the stockholder as interest income. The corporation is also allowed a corresponding deduction.

 

This "below market loan" rule is triggered once the total loan balance goes over $10,000. Paying your corporation's bills, without getting reimbursed, also counts as a loan.

 

The IRS is alerted to these type of loans by the corporation's tax return, which asks about "loans from stockholders." Here are three quick tips to avoid problems:

 

· Review any loans or expense advances made to your corporation. Consider whether the outstanding balance should be reduced to $10,000 or less.

 

· You may want to convert all, or part, of the loan to a capital contribution or purchase of stock. Consult with your tax adviser about the best way to capitalize your business.

 

· Consider formalizing the transaction by fixing an interest rate and payment schedule. Your tax adviser can suggest an acceptable interest rate that will stop the IRS from taxing you at a higher rate later if interest rates rise while the debt is outstanding.

 

· Keep good records showing that loan payments were made on schedule.