...(continued) It has been your practice in the past to book money given to the corporation as a loan so that the shareholder can be repaid principal tax-free. The client would like to know if this should be a loan or a capital contribution. What do you tell your client?


Answer:

Making a capital contribution gives the shareholder stock basis. Pass-through losses are allowed to the extent there is stock basis. Distributions from the corporation can be taken against stock basis tax-free and those exceeding stock basis are taxable. Loaning the corporation money gives the shareholder loan basis. Loan basis is tracked separately from stock basis. Pass-through losses are allowed against loan basis after stock basis has been reduced to zero. Because loan basis is restored first, any repayment of the loan will create taxable income. Loans must be properly documented with a stated interest rate. If there is no stated rate, the below market loan rules apply.

The answer depends on a number of things, but having basis, being allowed to claim pass-through losses and being taxed on distributions (or loan payments when loan basis has been reduced) puts the two on similar grounds except for interest income and the additional paperwork with loans. When there is more than one shareholder in a corporation and not all of them can contribute proportionately based on stock ownership, loans are an effective way to differentiate this ability. In a single shareholder S corporation, loans are not only highly scrutinized by the IRS, they are generally not effective and can have adverse tax consequences that are not present with capital contributions.