Loans From Shareholders: IRS Rules and Tax Treatment

When a shareholder lends money to their own corporation, the IRS treats the transaction with skepticism because both sides of the deal are effectively the same person. Loans from shareholders work as a tax-efficient way to fund a corporation only when the arrangement carries a written note, a fixed maturity, an interest rate at or above the monthly Applicable Federal Rate, and a real pattern of repayment. Fall short on any of those, and the IRS can recharacterize the loan as equity, impute interest that was never paid, or deny the corporation’s interest deduction outright.

Is It Really a Loan? The Debt-Versus-Equity Question

The threshold issue for any shareholder loan is whether it functions as debt at all. Under Section 385 of the Internal Revenue Code, the IRS weighs several factors together, and no single one controls: whether the parties signed an unconditional written promise to repay a fixed sum with stated interest, whether the debt is subordinated to other creditors, the corporation’s debt-to-equity ratio, whether the instrument could convert into stock, and whether debt holdings track the shareholders’ stock ownership percentages.¹

That last factor catches closely held corporations regularly. If two shareholders each own half the stock and each lend money in the same 50/50 split, it stops looking like arm’s-length lending and starts looking like capital in another wrapper. Courts also look for a fixed maturity date, a realistic repayment schedule, collateral, and whether the corporation could have borrowed the same amount from an outside lender. Repayment tied to profits, no maturity date, and thin capitalization all push toward equity treatment.²

What Happens if the IRS Recharacterizes the Loan

If the IRS successfully reclassifies the loan as equity, both sides take a hit. The corporation loses the interest deduction because the payments are now nondeductible distributions. For a C corporation shareholder, those same payments become taxable dividends instead of a mix of interest income and tax-free principal recovery. Repayment of “principal” is treated as a return of capital, tax-free only up to the shareholder’s stock basis, with anything beyond that taxed as capital gain.

Documentation the IRS Expects to See

A signed promissory note has to exist when the money changes hands, not afterward. Backdating a note in response to an IRS inquiry is both transparent and ineffective. The note should state the principal amount, a fixed maturity date, a repayment schedule for principal and interest, and an interest rate at or above the Applicable Federal Rate.

Spell out the shareholder’s remedies on default, including acceleration, late fees, and collection rights. Courts examine whether the shareholder genuinely expected repayment and would enforce collection if payments stopped.² A note that grants creditor rights on paper but is never enforced when payments are missed undercuts the whole arrangement. Board minutes or a resolution authorizing the loan should sit in the corporate records, and if the loan is secured, the security interest generally needs to be perfected by filing a UCC-1.

Setting the Interest Rate

Every shareholder-to-corporation loan must carry an interest rate that meets the arm’s-length standard, and the IRS sets the floor through the Applicable Federal Rates, published monthly. The AFR is based on the average market yield of U.S. Treasury obligations and comes in three tiers keyed to the loan’s term:³

Short-term, for loans of three years or less.
Mid-term, for loans over three years but not over nine.
Long-term, for loans over nine years.

The AFR changes each month, so the timing of the loan matters. For a term loan, the rate is locked in on the day the loan is made and does not change over its life. For a demand loan payable whenever the lender asks, the applicable rate is the short-term AFR and it floats, tested against each period’s short-term rate for as long as the loan is outstanding.⁴ Demand loans create more ongoing compliance work because the benchmark keeps moving.

Below-Market Loans and Imputed Interest

Charging zero interest, or a rate below the AFR, does not avoid tax. Section 7872 forces both parties to recognize “forgone interest” as though it had been paid: the shareholder is treated as having contributed additional capital equal to the shortfall, and the corporation is treated as paying that amount back as interest.⁵ The shareholder ends up with taxable interest income on money never received, and the corporation gets a matching deduction it never paid. The economic result mirrors an arm’s-length rate no matter what the note says.

The $10,000 De Minimis Exception

Section 7872 carves out a narrow safe harbor. The imputed interest rules do not apply to corporation-shareholder loans on any day when the total outstanding balance between the parties is $10,000 or less.⁴ The exception disappears if one of the principal purposes of the arrangement is federal tax avoidance, and it applies to the aggregate of all loans between the same parties, so splitting a larger balance into two notes does not help.

How the Corporation Reports and Deducts the Interest

With the loan properly structured, the corporation deducts interest paid to the shareholder just as it would interest on a bank loan. Section 163(a) allows a deduction for all interest paid or accrued on indebtedness during the taxable year.⁶ That deduction reduces taxable income dollar for dollar and is one of the main reasons shareholders fund corporations with debt rather than equity.

The Section 163(j) Cap

Larger corporations face a ceiling on the interest they can deduct in a year. Under Section 163(j), deductible business interest cannot exceed business interest income plus 30% of adjusted taxable income for the year, with any excess carrying forward.⁷ For taxable years beginning after December 31, 2024, adjusted taxable income is calculated by adding back depreciation, amortization, and depletion, a more generous formula than the one that applied from 2022 through 2024. Small businesses meeting the gross receipts test under Section 448(c) are exempt from the limitation entirely.

The Section 267 Timing Trap

Here is where shareholder loans create a problem most owners do not anticipate. If the corporation uses the accrual method and the shareholder reports on the cash method, as most individuals do, Section 267 prevents the corporation from deducting the interest until the shareholder actually receives it.⁸ Accruing interest on the books without cutting checks means the corporation books an expense it cannot yet deduct. Corporations that let interest accrue for years can find deductions stuck in limbo.

How the Shareholder Reports the Income

Interest received from the corporation is ordinary income, reported on the shareholder’s personal return in the year received for cash-method taxpayers, or accrued for accrual-method taxpayers. Section 61 lists interest as gross income.⁹ There is no preferential rate: interest is taxed at the shareholder’s ordinary marginal rate, not the lower rates for qualified dividends or long-term capital gains. Repayment of principal is not taxable; it is a return of the money originally lent and reduces the shareholder’s basis in the loan.

Net Investment Income Tax

Higher-income shareholders owe an additional 3.8% Net Investment Income Tax on the interest. The NIIT applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $250,000 for joint filers, $200,000 for single filers, or $125,000 for married filing separately.¹⁰ Interest from a shareholder loan falls squarely within the NIIT base. A shareholder in the top bracket can face a combined federal rate above 40% on this income.

Form 1099-INT

The corporation must issue Form 1099-INT to the shareholder for any calendar year in which it pays $10 or more in interest, with a copy to the IRS.¹¹ Skipping the form does not change the shareholder’s obligation to report the income, but it invites penalties on the corporation and flags the arrangement for broader scrutiny.

S Corporation Loans and Debt Basis

Loans to S corporations do something loans to C corporations do not: they create “debt basis” for the lending shareholder. That matters because pass-through losses from an S corporation are deductible on the shareholder’s personal return only up to the combined total of stock basis and debt basis.¹²

The loan has to come directly from the shareholder. A shareholder who borrows from a bank and re-lends the proceeds to the corporation gets debt basis. A shareholder who only guarantees a bank loan made directly to the corporation does not, even though the economic exposure looks similar. When pass-through losses reduce debt basis, subsequent net income restores that debt basis before it starts increasing stock basis. Repayment of the loan while basis is still reduced can trigger a taxable gain, so the sequence in which money moves matters.

If the Loan Becomes Worthless

If the corporation fails, the shareholder may claim a bad debt deduction. For most shareholders this is a nonbusiness bad debt, deductible only as a short-term capital loss and subject to the annual $3,000 capital loss limitation against ordinary income.¹³ The loss is reported on Form 8949.

Two requirements trip people up. The debt must be totally worthless before any deduction is available; partial worthlessness does not count for nonbusiness bad debts. The shareholder must show there is no reasonable expectation of repayment and that reasonable collection efforts were made, though pursuing a clearly uncollectible judgment is not required. A detailed statement describing the debt, the debtor, the amount, collection efforts, and the reason for worthlessness has to be attached to the return.¹³

A shareholder who can show the loan was primarily motivated by their trade or business rather than their investment may qualify for business bad debt treatment, which allows a deduction against ordinary income instead of the capital loss cap. That is a hard standard for a typical shareholder-investor to meet, but worth evaluating when the loss is large. The deduction can only be taken in the year the debt actually becomes worthless. The statute of limitations for bad debt claims is seven years rather than the usual three, giving shareholders a longer runway when the worthlessness is only recognized later.

1
Office of the Law Revision Counsel. 26 U.S. Code 385 – Treatment of Certain Interests in Corporations
2
Internal Revenue Service. Valid Shareholder Debt Owed by S Corporation
3
Office of the Law Revision Counsel. 26 USC 1274(d) – Determination of Applicable Federal Rate
4
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
5
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
6
Office of the Law Revision Counsel. 26 USC 163 – Interest
7
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
8
Office of the Law Revision Counsel. 26 U.S. Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
9
Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined
10
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
11
Internal Revenue Service. About Form 1099-INT, Interest Income
12
Office of the Law Revision Counsel. 26 U.S. Code 1367 – Adjustments to Basis of Stock of Shareholders
13
Internal Revenue Service. Topic No. 453, Bad Debt Deduction