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Business Loan or Capital Investment?

If you loan personal funds to a corporation or partnership where you are a shareholder or partner there are steps you need to take to classify the cash contribution as a business loan.

The proof of a business loan can be a difficult thing to determine and there is no clear statutory answer provided by the IRS Code or regulations. The IRS will look at all conditions and circumstances including fixed rate of interest, payments, a written document in form of note or loan instrument, other financing available and any prior capital investment.

A business loan needs to be an armís length relationship with:

  • Contract with payment schedules,
  • Fair market interest rates,
  • Term of payment,
  • A penalty for late payment or lack of payment,
  • Possible collateral and ,
  • Process for termination.

A schedule of payments to the end of term and regular statements from the corporation or partnership would also show this is a purely business loan relationship verse a capital investment in the business. If the business issues a 1099-INT to the shareholder this would further prove the intention of the cash contribution to be a loan. The tax effect for the shareholder/partner would cancel out as the business deducts it, and the shareholder includes as income.

The result of the IRS re-characterizing the loan as a capital investment is the cash contribution stays on the business books as Paid In Capital or Partner Account Balance. Any interest and loan payment would be considered distributions to shareholder/partners and subject to additional tax and may be subject to self-employment tax for partners.

Also be aware a business loan is possible for corporation or S-corporation shareholders and partners in a partnership. Sole proprietors who file a Schedule C on their personal return cannot lend money to themself and have it be considered a business loan. Follow the list of items above for your shareholder or partner loan, keep adequate proof with documentation and you should avoid IRS re-characterizing the loan.

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