Can I Borrow Money From My S Corporation? IRS Rules and AFR

You can borrow money from your S corporation, but the transaction has to look and behave like a real loan between unrelated parties. That means a signed promissory note, an interest rate at or above the IRS Applicable Federal Rate (currently roughly 3.6% to 4.7% depending on the term), a fixed repayment schedule, and payments you actually make on time. Miss any of those elements and the IRS can reclassify the withdrawal as wages or a distribution, with tax, payroll tax, and penalties attached.

Why Take a Loan Instead of a Distribution

The reason shareholders go through the paperwork rather than simply pulling a distribution comes down to stock basis. A distribution reduces your stock basis dollar for dollar, and once basis hits zero, every additional dollar is taxed as capital gain.¹²

A bona fide loan doesn’t touch basis. The cash leaves the company, but because you’re legally obligated to return it, the transaction is basis-neutral. That matters most when the corporation is also passing through losses you want to deduct, since you need enough basis to claim them and distributions eat that cushion while loans do not.¹

The trade-off is interest. Payments you make back to the corporation are interest income to the S corp, which passes through to all shareholders on their K-1s.³ For most shareholders, that ongoing cost is worth it when the alternative is burning through basis or triggering capital gains.

What the IRS Considers a Real Loan

Internal Revenue Code Section 7872 targets below-market loans between corporations and shareholders and authorizes the IRS to recharacterize transactions whose terms don’t reflect an arm’s-length deal.⁴ Internal IRS guidance for examiners lists what auditors look for: whether repayment is reasonably expected, whether the borrower actually made payments on schedule, whether the lender has real remedies on default (collateral, a security interest), and whether the corporation genuinely intended to collect.⁵

The Seventh Circuit’s decision in Busch v. Commissioner shows how the analysis plays out. The court weighed the shareholder’s control over the company, dividend history, size of the withdrawals, whether notes covered the full amount, whether those notes had a maturity date and interest terms, the shareholder’s repayment history, and how the advances were recorded on the books. Busch failed almost every factor — no maturity dates, no interest, no collateral, and no dividends despite growing retained earnings — and the withdrawals were taxed as dividends.⁶

The Applicable Federal Rate

The IRS publishes the Applicable Federal Rate monthly, and every shareholder loan must charge interest at or above the rate for its term.⁷ The term categories come from IRC Section 1274(d):⁸

Short-term (3 years or less): 3.59% annual for March 2026
Mid-term (over 3 years, up to 9 years): 3.93% annual for March 2026
Long-term (over 9 years): 4.72% annual for March 2026

You lock in the rate for the month the loan is issued.⁹ Charge less than the AFR and the IRS treats the gap as forgone interest: the corporation is deemed to transfer the uncharged interest to you, and you’re deemed to hand it back. That deemed transfer can be characterized as compensation (triggering payroll taxes) or as a distribution (cutting into basis).⁴

What Reclassification Costs

If the IRS treats the withdrawal as compensation, the corporation owes the employer share of FICA and FUTA, you owe the employee share (a combined 15.3% for Social Security and Medicare), and there’s federal income tax withholding that should have been collected.¹⁰ Add a failure-to-pay penalty of 0.5% per month on the unpaid tax, capped at 25%.¹¹

If it’s treated as a distribution instead, the money reduces stock basis, and anything above basis becomes capital gain.² Either way, interest on the underpayment runs back to the original return due date.

The $10,000 Small-Loan Exception

Section 7872 carves out a narrow exception. If the total outstanding balance between you and the corporation stays at or below $10,000 on every day of the year, the below-market interest rules don’t apply, and you can technically charge zero interest without imputed-interest consequences.⁴

The exception disappears if a principal purpose of the interest arrangement is federal tax avoidance. The IRS doesn’t have to show it was the only purpose, only that avoidance was a significant motivation. And the exception only spares you the below-market rules; it does not spare you the loan-vs.-distribution analysis. A signed note and repayment schedule still matter, because the IRS can still argue the withdrawal was never a loan at all.

Pay Yourself a Reasonable Salary First

This is where most shareholder-loan strategies unravel. Before borrowing anything, you need to be paying yourself reasonable W-2 wages for the work you actually do. The IRS has stated the point directly: S corporations should not try to avoid employment taxes by treating officer compensation as distributions, personal expenses, or loans.¹²

Courts have upheld the IRS reclassifying so-called loans as wages subject to FICA and FUTA when the shareholder performed substantial services and the loan terms were sham-like: no interest, unsecured, made at the shareholder’s discretion, with repayments that amounted to paper offsets against other amounts the corporation owed the shareholder.¹⁰ Taking a loan from a corporation that has never run payroll for you paints a target on the return.

Drafting the Promissory Note

The note is the single most important document. Without one, you’re relying on verbal understandings and bookkeeping entries, which is essentially the Busch fact pattern. A complete note names the corporation (full legal name) as lender and you as borrower, and covers:

The exact principal amount
An interest rate at or above the AFR for the month the loan is made, using the annual compounding rate from the current revenue ruling⁹
A repayment schedule with specific due dates and dollar amounts
A fixed maturity date
Default provisions covering late fees, acceleration of the balance, and recovery of collection costs
Any collateral pledged, such as real estate or the shareholder’s stock

The documentation needs to exist at or before disbursement, not after an audit notice arrives. Backdating a note is one of the fastest ways to destroy credibility.

Executing the Loan

Once the note is signed, the corporation should disburse the funds by wire or check so there’s a dated paper trail. Cash gives auditors nothing to work with.

The board should adopt a resolution authorizing the loan before the money moves, with formal minutes describing the amount, interest rate, terms, and business rationale. Sole-shareholder, sole-director S corps still need this. Courts and the IRS look for evidence you treated the corporation as a separate entity, and the minutes are that evidence.

On the books, the corporation records the loan as a Note Receivable, an asset. The bookkeeper should maintain an amortization schedule splitting each payment between principal and interest.

Managing Repayment

Consistent, documented payments are the strongest proof the loan is real. Payments should flow through a bank account and match the schedule in the note. Each payment reduces the Note Receivable and generates interest income, which passes through to all shareholders on their K-1s and gets reported on their individual returns.¹³

Loans that sit on the books for years with no collection activity are exactly what auditors flag as disguised distributions. If you genuinely can’t make a payment, don’t just stop. Formally amend the note — extend the maturity date, revise the schedule, or add a forbearance period — with signatures from both sides and updated board minutes. The paper trail of the modification itself shows the corporation is exercising oversight.

When the loan is paid off, the corporation should issue a written release confirming satisfaction. Keep it with the original note, all payment records, and the corporate minutes. The IRS can reach back several years, so these records need to outlive the final payment.

Reporting on the Returns

A loan owed by a shareholder to the corporation appears as an asset on Schedule L of Form 1120-S. When the direction runs the other way and the corporation owes the shareholder, that balance is reported on Schedule L, line 19, and the shareholder’s beginning and ending debt balance appears in Item I of the K-1.³

Interest income the corporation earns on the loan flows through to shareholders on the K-1 as separately stated income, and the borrowing shareholder reports their share on Schedule B.¹³ For a sole shareholder charging the minimum AFR, that means paying interest to yourself through the corporation, but both sides of the transaction still have to be reported.

If the below-market rules do apply, reporting gets more complex. For a term loan, the corporation reports original issue discount as interest income, and the shareholder may be able to deduct the corresponding amount as investment interest expense on Schedule A, subject to the Form 4952 limits. For a demand loan, the corporation reports the forgone interest as income each year the loan is outstanding.¹³

What Happens If the Loan Is Forgiven

If the corporation forgives the loan rather than collect it, the canceled amount is generally taxable to you as ordinary income, and the corporation may issue a Form 1099-C for the year of cancellation.¹⁴

Forgiveness also has a corporate-side effect. The IRS may treat the write-off as a distribution rather than a deductible bad debt, which reduces your stock basis just like any other distribution, and any excess over remaining basis becomes capital gain.² So forgiveness can hit twice: ordinary income from cancellation and capital gain from the basis reduction. The narrow exclusions for canceled debt income (bankruptcy, insolvency, qualified principal residence indebtedness) rarely apply in a shareholder-corporation setting.

A loan the parties never really intended to collect — one that just sits until it’s eventually written off — is the classic disguised distribution. The IRS doesn’t need to wait for formal forgiveness. On audit, the transaction gets recharacterized back to the year the money was originally withdrawn, with tax, penalties, and interest running from that date.

When There Are Other Shareholders

Corporate cash you borrow belongs, indirectly, to every shareholder. A controlling shareholder who authorizes a loan to themselves is on both sides of the deal, which triggers the entire-fairness standard of judicial review rather than the business judgment rule if it’s ever challenged.

Before approval, get informed consent from the other shareholders. Where a board functions, a committee of independent directors can review the terms. In a closely held S corp with lighter formalities, at minimum give every shareholder written notice of the terms and an opportunity to object, and record the consent in the minutes.

Protecting the Corporate Veil

The tax risks aren’t the only ones. Casual withdrawals — no board approval, no notes, no repayment — become evidence of alter-ego behavior. In an unrelated lawsuit later on, a plaintiff can point to that pattern to argue the corporate veil should be pierced, exposing you personally to the corporation’s debts.

The fix is the same discipline that keeps the IRS satisfied: formal documentation, board resolutions, a market-rate interest charge, and consistent repayment. Treat the loan the way a bank would treat a commercial borrower, and both the tax and liability exposures stay contained.

1
Internal Revenue Service. S Corporation Stock and Debt Basis
2
Office of the Law Revision Counsel. 26 USC 1368 – Distributions
3
Internal Revenue Service. Instructions for Form 1120-S
4
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
5
Internal Revenue Service. Valid Shareholder Debt Owed by S Corporation
6
Justia Law. Busch v. Commissioner, 728 F.2d 945 (7th Cir. 1984)
7
Internal Revenue Service. Applicable Federal Rates
8
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments
9
Internal Revenue Service. Rev. Rul. 2026-6
10
Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
11
Internal Revenue Service. Failure to Pay Penalty
12
Internal Revenue Service. Wage Compensation for S Corporation Officers
13
Internal Revenue Service. Publication 550 – Investment Income and Expenses
14
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?