Since the post on computing S Corporation shareholder basis is still my most popular blog post ever, I thought I would add a follow up post on classifying shareholder cash transfers. For the sake of simplicity, let’s assume we’re dealing with an individual who is the sole (100%) owner of an S Corporation.
I typically see three kinds of shareholder cash transfers in S Corporation QuickBooks files:
- non-deductible personal expenses
- lump sum distributions to shareholder
- loan from shareholder to S Corp
The first transfer is usually classified as a debit to a Loan to Shareholder Asset account and a credit to Cash. But is this correct? Not according to the Sub Chapter S Shareholder Basis Considerations presentation prepared by Jennifer L Davis, EA, ATA, ATP, Davis & Associates, Accountants, Inc. Slide 42 asks whether personal charges should be a) classified as Loan to Shareholder, or b) as a distribution that reduces Loan Basis until Loan Basis reaches zero then as non-dividend distributions. The answer, given on slide 43, is b, with a note that if both Stock and Loan (Debt) Basis are zero, the “excess would be a taxable distribution as a capital gain.”
What about lump sum distributions? Slide 8, Distributions vs. Loan to Shareholder says that non-dividend distributions (S Corporations do not pay dividends) can be taken from current-year or retained earnings, up to the maximum non-taxable distribution, which is current year + retained earnings. If a non-dividend distribution exceeds this maximum, it should be treated as a loan to shareholder to be repaid from personal funds or via earnings in subsequent years.
In other words, the Loan to Shareholder account should not be used to permanently classify cash outflows to the shareholder. It should be cleared via reduction of loan basis, repayment or distribution. If the shareholder needs to get cash out of an S Corporation that has a loss or insufficient earnings to pay wages and distributions from earnings, check these detailed IRS guidelines or this shorter, easier-to-read version of those guidelines to see if a loan will meet the test of being treated as a bona fide loan in the event of an audit. The shorter document highlights these points supporting a bona fide loan:
- deficit or no earnings,
- arm’s length transaction (minimal shareholder control),
- ability of shareholder to repay,
- security given,
- note receivable,
- repayment schedule,
- attempts to repay,
- maturity date,
- interest accrual,
- collection attempts,
- magnitude of advances, and
- limit on advances.
Note that if earnings were sufficient to pay but were not used to pay a reasonable salary, the cash advances may be reclassified as wages subject to employment taxes.
What about making a loan to the S Corp from shareholder personal funds? The article “S shareholder’s note payable and note receivable as two separate items,” The Tax Adviser 25.n12 (Dec 1994): 749(2) by Joseph V. Pease Jr. discusses whether an S Corp can legitimately have Loan to Shareholder and Loan from Shareholder account balances present simultaneously or if the former must be netted against the latter. The article makes the case that you can have both accounts present as long as they are separately and legitimately established. However, the article is dated: there may have been subsequent IRS guidance on this point. I did find a large number of articles dealing with the controversy of using loans from shareholders to establish tax basis. For example, this article, which emphasizes the importance of establishing basis via personal funds or funds borrowed from a third party, not via debt guarantees or loans from commonly controlled entities. There are too many links to include here, but since the main point of most of these articles is that it’s important to legitimately establish loan basis, I would definitely suggest asking your tax advisor whether you should keep an open Loan to Shareholder balance or net it against the Loan from Shareholder account.
A final thought regarding treatment of non-deductible personal expenses. According to John R. Dundon, these reduce bases before loss and deduction items and do not get carried forward, but per Regs. Sec. 1.1367-1(g) Elective ordering rule, you can change the order of basis adjustments as indicated, but if you do, you agree to carry forward any nondeductible noncapital expenses that cannot reduce basis because the expenses exceed basis.
Disclaimer: This blog is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice. Be sure to consult a tax or financial advisor before making important financial decisions.
