Shareholder Loan Interest: AFR, Deduction, and Imputed Income

Interest on a shareholder loan is deductible by the corporation and taxable as ordinary income to the shareholder, provided the IRS accepts the arrangement as a real loan rather than a disguised capital contribution. That single qualifier drives every tax rule that follows, because if the loan fails the debt-versus-equity test, the corporation loses the deduction, the payments turn into dividends or distributions, and a 20% accuracy-related penalty can land on top. The shareholder loan interest tax rules below cover what the IRS looks for, how the deduction and income actually work on each side, and the below-market and timing traps that catch closely held businesses most often.

When the IRS Treats It as a Real Loan

Section 385 of the Internal Revenue Code authorizes the Treasury to lay out factors separating debt from equity, and the statute itself points to a written promise to pay a fixed amount with interest, whether the obligation is subordinated to other debts, the corporation’s debt-to-equity ratio, whether interest can convert to stock, and the overlap between stock ownership and loan holdings.¹ Courts have added factors over the years, including the corporation’s ability to borrow from outside lenders and whether the loan tracks each shareholder’s stock ownership. No single factor controls. In practice, the arrangement needs to look like something a bank would recognize.

Documentation and a Market Rate

Start with a written promissory note that states the principal, a fixed maturity date, a repayment schedule for principal and interest, and a stated interest rate. The board should authorize the loan by resolution or written consent, the same way it would approve third-party financing. Without an enforceable note and corporate authorization, the IRS has an easy argument that the money was equity.

The rate has to reflect what an unrelated lender would charge, and the IRS benchmarks it against the Applicable Federal Rate published monthly. For February 2026, the short-term AFR (loans of three years or less) is 3.56%, the mid-term AFR (over three years up to nine years) is 3.86%, and the long-term AFR (over nine years) is 4.70%, all compounded annually.² Charge less and Section 7872 kicks in with imputed interest, discussed further below.³

Repayments the Shareholder Actually Enforces

The shareholder-lender needs the same rights an outside creditor would have, including the right to demand repayment and enforce the note. If the loan is subordinated to other corporate debts, it starts to look like risk capital. If the corporation misses payments for years and nobody enforces anything, or the maturity date keeps getting extended, the IRS will argue the parties never intended a real debtor-creditor relationship. Treat the note the way you would treat a bank loan, because that is the comparison the IRS draws.

Capitalization and Collateral

A corporation funded almost entirely with shareholder loans and little equity is thinly capitalized, which is one of the strongest signals for reclassification. No single debt-to-equity ratio is automatic, but ratios above 3-to-1 attract scrutiny. Collateral helps: if the corporation pledges assets to secure the shareholder loan the way it would for a bank, the arrangement looks more like real debt. An unsecured shareholder loan sitting behind fully secured bank debt points the other direction.

How the Corporation Deducts the Interest

When the loan is genuine debt, the corporation deducts the interest under Section 163 as a business expense.⁴ The mechanics depend on whether the entity is a C-corporation or an S-corporation, and on two further rules that catch owners off guard.

C-Corporation

A C-corporation deducts interest expense from gross income on Form 1120. With the current flat 21% federal corporate rate, every dollar of deductible interest saves roughly 21 cents of federal tax. That deduction is one of the main reasons closely held C-corporations prefer debt financing to additional equity.

S-Corporation

An S-corporation generally pays no entity-level federal income tax. The interest deduction flows through to shareholders on Schedule K-1 and reduces each shareholder’s individual taxable income pro rata.⁵

A direct shareholder loan also creates “debt basis” separate from stock basis. If corporate losses exceed a shareholder’s stock basis, the shareholder can still deduct losses up to their debt basis from loans they personally made. A loan guarantee is not enough; the shareholder must have actually lent the money.⁶ Once losses reduce debt basis, future income from the S-corporation restores it before loan repayments can come back as tax-free principal.

The Section 267 Timing Trap

When a shareholder owns more than 50% of the stock (direct and constructive ownership combined), the shareholder and the corporation are related persons under Section 267.⁷ If the corporation uses accrual accounting and the shareholder uses the cash method, the corporation cannot deduct accrued interest until the shareholder actually receives it and reports it as income.

An accrual-basis corporation that books interest expense at year-end but doesn’t cut the check until the following year loses the deduction in the earlier year. The fix is simple: pay the interest before year-end so the deduction and the income land in the same tax year.

The 163(j) Business Interest Cap

Even legitimate interest can hit a ceiling. Section 163(j) limits a taxpayer’s deductible business interest expense for the year to the sum of business interest income plus 30% of adjusted taxable income, with any excess carried forward indefinitely.⁸ A small-business exemption applies when average annual gross receipts over the prior three years do not exceed an inflation-adjusted threshold, which is $31 million for 2025, with a slightly higher figure expected for 2026. Most closely held businesses are below the threshold, but higher-revenue companies need to model the cap before structuring large shareholder loans.

How the Shareholder Reports the Income

Interest the shareholder collects on a legitimate loan is ordinary income taxed at the shareholder’s marginal rate.⁹ There is no preferential rate for interest the way there is for qualified dividends. The shareholder reports it on Schedule B of Form 1040, and the corporation must issue Form 1099-INT when total interest paid to the shareholder reaches $10 or more during the year.¹⁰

If a shareholder does not materially participate in the corporation’s operations, the interest income could be classified as passive under Section 469, which matters because passive income only offsets passive losses.¹¹ The self-charged interest regulations exist to prevent a mismatch where a shareholder lending to a pass-through entity ends up with passive interest income on one side and a non-passive flow-through deduction on the other. They recharacterize the shareholder’s interest income as non-passive to the extent the entity’s corresponding deduction is non-passive. For owner-operators who materially participate, income and deduction stay in the same bucket.

Below-market term loans add a wrinkle. Imputed interest under Section 7872 can create original issue discount; if total OID for the year is $10 or more, the corporation reports it on Form 1099-OID rather than Form 1099-INT. For loans of one year or less, OID is reported on Form 1099-INT instead.¹⁰ A loan with both stated interest and OID can be reported entirely on Form 1099-OID or split between the two.

Below-Market Loans and Imputed Interest

Section 7872 targets below-market loans between a corporation and its shareholders.³ If the stated rate is below the AFR, the IRS treats the gap as “forgone interest” and imputes two deemed transactions: the corporation is treated as transferring the forgone amount to the shareholder (typically as a dividend), and the shareholder is treated as paying it right back as interest. Real tax follows cash that never moved.

Take a $200,000 shareholder loan at 0% when the applicable AFR is 3.86%. The forgone interest of roughly $7,720 is a deemed dividend from the corporation to the shareholder and a deemed interest payment back. The shareholder has dividend income and imputed interest income. The corporation gets the interest deduction but no deduction for the deemed dividend. The net result is worse than simply charging the AFR to begin with.

The calculation differs by loan type. A demand loan, payable whenever the lender asks, is recalculated each year using the blended annual AFR, so the imputed amount can move with rates. A term loan with a fixed schedule is measured once at origination: the IRS compares the amount lent to the present value of all future payments discounted at the AFR on the day the loan was made, and the shortfall is treated as transferred upfront, creating original issue discount that amortizes over the loan’s life.

There is a narrow safe harbor. Corporation-shareholder loans are exempt from imputation if the total outstanding balance between the parties stays at or below $10,000 on every day of the year.³ The threshold is aggregate: multiple advances that together cross $10,000 on any single day knock out the exception for the full amount, not just the excess. Daily balance tracking is the only reliable way to stay inside it. A separate de minimis rule tied to net investment income exists in Section 7872(d), but it applies only to gift loans between individuals, not to corporation-shareholder loans; relying on the wrong exception is a costly mistake.

What Reclassification Costs

If the IRS successfully recharacterizes a shareholder loan as a capital contribution, the consequences run through both returns:

The corporation loses the interest deduction. Every deducted interest payment becomes non-deductible, and the corporation owes additional tax plus underpayment interest from the original due date.
For a C-corporation, the reclassified payments become dividends. They may qualify for the qualified-dividend rate for the shareholder, but they remain non-deductible to the corporation.
For an S-corporation, the payments become distributions that reduce the shareholder’s stock basis and turn into capital gain once basis is exhausted.
The corporation files an amended Form 1120 or 1120-S, the shareholder may need to amend Form 1040, and the reclassified payments are reported on Form 1099-DIV rather than Form 1099-INT.¹²

The expensive part is the double hit: the corporation loses its deduction while the shareholder still owes tax on the payments.

Audit Window and Penalties

The IRS generally has three years from the date a return is filed (or its due date, whichever is later) to assess additional tax. If the reclassification causes the taxpayer to report 25% or less of actual income, the window extends to six years. Fraudulent returns have no time limit.¹³

Accuracy-related penalties under Section 6662 apply at 20% of any underpayment caused by negligence, disregard of rules, or a substantial understatement of income tax; a gross valuation misstatement bumps the penalty to 40%.¹⁴ These sit on top of the additional tax and interest. The best defense is the paperwork at the front end: a signed note, a board resolution, an AFR-based rate, timely payments actually made and recorded, and a 1099-INT issued when the $10 threshold is crossed. That record often supports a reasonable-cause argument that eliminates the penalty even if the debt-versus-equity question goes against the taxpayer.

1
Office of the Law Revision Counsel. 26 USC 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
2
IRS. Revenue Ruling 2026-3
3
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
4
Office of the Law Revision Counsel. 26 USC 163 – Interest
5
Internal Revenue Service. Instructions for Schedule K-1 Form 1120-S
6
Internal Revenue Service. S Corporation Stock and Debt Basis
7
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
8
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
9
Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
10
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
11
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
12
Internal Revenue Service. Instructions for Form 1099-DIV
13
Internal Revenue Service. Time IRS Can Assess Tax
14
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments