Proceed With Caution When Taking a Loan From Your Business

Should you ever consider borrowing money from your business, you will want to pay special attention to potential tax consequences. Here are things to consider to avoid potentially turning an innocent business loan into an unexpected tax bill.

The problem

The IRS likes to see business owners who dot all their i’s and cross all their t’s. For owners who borrow money from their business, the IRS wants to see evidence that the borrowed money is an actual loan. If the IRS selects your tax return for an audit and can’t find this evidence, it may decide to treat the money as taxable wages or dividends instead of a loan.

In addition to possible legal and tax implications, taking money from your business may put a strain on cash flow. Even if your business is profitable, removing money that would otherwise be used for operations and growth opportunities could hinder your company’s ability to function day-to-day.

Implications

• Deemed wages. If a personal loan from the business is deemed wages, you will need to pay Social Security and Medicare taxes, plus penalties.
• Deemed dividend or return of capital. How the IRS treats this will depend on how your business is organized and whether you have basis to provide the funds distributed to you. The rules and tax rates get complex fairly quickly. And if the personal loan turns your basis into a negative balance, it may limit the amount of loses you can report on your tax return.
• Tax rates applied to reclassified personal loans vary. The tax rates applied to a reclassified personal loan could be as low as zero or as high as 37% plus potential surcharge taxes of 0.9% or 3.8%.

The lesson here is a personal loan from your business is typically a bad tax idea, or one that should be done in conjunction with a tax planning discussion.

What you can do

If a personal loan is still in the cards for you, to avoid a possible dispute with the IRS regarding this loan, consider the following:

• Ensure you are paying yourself a fair wage prior to considering a personal loan.
• Sign a legally enforceable promissory note prior to any cash withdrawal.
• If you’re a corporation, documentation must also include the authorizing of the loan in company minutes.
• The promissory note needs to disclose the terms of the note. This includes, but is not limited to, the length of the note, the interest rate, the amount borrowed and repayment requirements.
• Interest rates must be reasonable. Use at least minimum rates as published in the federal register each month.
• Record the transaction as a loan in your business’s accounting system.
• Show evidence of repayment per the terms in the promissory note.

But remember, even if you do all of this, the facts and circumstances surrounding the loan may still be challenged by the IRS.