What Is a Director’s Loan and How Is It Taxed?

A director’s loan is taxed based on whether the IRS accepts it as a real debt. If the arrangement is properly documented and carries interest at or above the Applicable Federal Rate, the director’s loan tax treatment is straightforward: the corporation reports interest income, and the director repays principal without further tax consequences. If the interest is too low, the IRS imputes the missing interest and taxes it as a dividend or compensation. If the loan lacks economic substance, the entire balance can be reclassified as a taxable distribution. And if the company forgives the debt, the forgiven amount becomes income to the director.

The rules below apply to private companies. Public companies face a separate federal prohibition covered at the end.

What Counts as a Director’s Loan

A director’s loan is any money moving between a corporation and one of its directors or officers outside of salary, dividends, or expense reimbursements. Companies track these movements through a director’s loan account, an internal ledger showing whether the director owes the company (an overdrawn balance) or the company owes the director (a credit balance).

The ledger matters because it’s the first thing the IRS looks at. A loan from a director should appear as a payable to the shareholder on the corporate balance sheet, and a loan to a director should appear as a receivable. Inconsistent bookkeeping, or no bookkeeping at all, is one of the fastest ways to lose the debt characterization and trigger reclassification.

The Below-Market Interest Rule

Federal tax law does not let a corporation lend money to a director at a favorable rate without tax consequences. Under 26 U.S.C. § 7872, any loan between a corporation and a shareholder, or between an employer and an employee, that charges interest below the Applicable Federal Rate is a “below-market loan.”¹ The IRS treats the lender as having charged the full AFR and then treats the shortfall, called the forgone interest, as a separate taxable transaction.

How the forgone interest is taxed depends on the relationship:

On a corporation-to-shareholder loan, the forgone interest is a deemed dividend from the corporation to the shareholder, then a deemed interest payment back to the corporation. The shareholder owes tax on the dividend; the corporation may owe tax on the interest income.
On an employer-to-employee loan, the forgone interest is deemed additional compensation to the employee, then deemed interest paid back to the employer. The employee owes income tax on the compensation, and employment taxes may apply.

When the director is both an employee and a shareholder, which is the usual situation in a closely held company, the IRS characterizes the imputed amount based on the relationship that gave rise to the loan.¹

The Applicable Federal Rate

The AFR is the minimum interest rate the IRS requires on related-party loans. It changes monthly and has three tiers based on loan duration. For January 2026, the annual compounding rates were:

Short-term (up to 3 years): 3.63%
Mid-term (over 3 years, up to 9 years): 3.81%
Long-term (over 9 years): 4.63%

These rates appear in monthly IRS Revenue Rulings.² For a term loan, the applicable rate is generally the one in effect when the loan is made. For a demand loan, it’s the rate in effect during each period the loan remains outstanding. A director taking a two-year loan in January 2026 would need to charge at least 3.63% to avoid Section 7872 treatment.

The $10,000 De Minimis Exception

Section 7872 does not apply on any day when the total outstanding loan balance between the borrower and the corporation stays at or below $10,000. The exception covers both compensation-related loans and corporation-shareholder loans.¹ It’s a fixed statutory amount and isn’t adjusted for inflation.

There’s a catch. The exception disappears entirely if one of the principal purposes of the interest arrangement is avoiding federal tax. A zero-interest loan structured to sit just below $10,000 specifically to dodge imputed interest would not qualify. The IRS looks at the purpose of the arrangement, not just the balance.

When the IRS Reclassifies the Loan Entirely

Imputed interest is the mild outcome. The harder tax hit comes when the IRS decides the “loan” was never a real debt. If a purported loan to a shareholder-director fails the economic-substance test, the entire outstanding amount can be reclassified as a constructive dividend, taxable to the director and not deductible by the corporation.

Courts and the IRS evaluate whether a corporate loan is bona fide debt by looking at:

Whether a written promissory note exists, naming lender, borrower, principal, and date
Whether there’s a fixed maturity date
Whether the stated interest rate meets the AFR
Whether the terms would be enforceable under state law
Whether the borrower has actually been making payments consistent with those terms
Whether the borrower’s financial position makes repayment realistic
How the transaction was recorded on the company’s books

A loan with no note, no maturity date, and no repayment history looks like a dividend in disguise. The absence of a formal instrument doesn’t automatically make an advance equity, but it pushes the analysis in that direction.³ A maturity date that keeps getting postponed is another warning sign. So is a pattern where the director’s withdrawals steadily increase and the corporation never makes any effort to collect.

The tax consequences of reclassification depend on which label the IRS picks. A constructive dividend is taxable to the shareholder at dividend rates, and the corporation gets no deduction. If the IRS instead characterizes the amount as compensation, which is more common when the director is primarily an employee, it becomes ordinary income and may be subject to employment taxes, though the corporation typically gets a corresponding deduction. Either outcome usually comes with penalties and interest on top.

When the Loan Is Forgiven

If the corporation writes off the director’s outstanding balance rather than collecting it, the forgiven amount becomes taxable income to the director. Under 26 U.S.C. § 61(a)(11), gross income includes “income from discharge of indebtedness.”⁴ The full forgiven amount is added to income in the year the debt is cancelled.

Section 108 offers limited exclusions. A director could exclude the forgiven amount if the discharge happens during a bankruptcy proceeding or while the director is insolvent, meaning liabilities exceed assets. Qualified farm indebtedness and qualified real property business indebtedness have their own separate exclusion rules.⁵ In the ordinary situation of a solvent director whose company simply writes the balance off, none of these apply.

The classification of the forgiven amount matters. If it’s treated as compensation for services, it can trigger employment taxes in addition to income tax. If treated as a constructive dividend, it escapes employment tax but isn’t deductible by the corporation. Which label applies depends on whether the director received the original loan primarily as a shareholder or as an employee.

Documentation and Reporting

Every element that supports debt treatment needs to exist in writing before an audit, not after. That means a signed promissory note, a stated interest rate at or above the AFR, a fixed maturity date, enforceable terms, and a record of actual repayments. It also means consistent bookkeeping: the loan should appear on the corporate balance sheet, and the corporation and the director should treat the transaction the same way on their respective records.³

Federal reporting adds another layer. Form 1120 Schedule L requires C corporations to report “Loans to shareholders” on line 7, showing beginning and end-of-year balances. S corporations report similar figures on Form 1120-S.⁶ Understating or omitting these balances is itself a red flag. Any Section 7872 imputed interest has to be reflected on both returns: the corporation reports the deemed interest income, and the director reports the deemed dividend or compensation. A forgiven loan treated as compensation is reported as wages on the director’s W-2.

State reporting varies, but many states require disclosure of related-party transactions in annual reports or state tax filings.

If the Company Is Publicly Traded, the Loan Isn’t Allowed

The rules above apply only to private companies. If the corporation is publicly traded, personal loans to directors and executive officers are prohibited outright. Section 13(k) of the Securities Exchange Act of 1934, added by Section 402 of the Sarbanes-Oxley Act, makes it unlawful for an issuer to “extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan” to any director or executive officer.⁷ Violations expose the company to civil and criminal penalties under the Exchange Act. For a public-company director, the question of how the loan would be taxed doesn’t arise, because the loan can’t legally be made.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Applicable Federal Rates for January 2026
3
Internal Revenue Service. Valid Shareholder Debt Owed by S Corporation
4
Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
5
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
6
Internal Revenue Service. U.S. Corporation Income Tax Return
7
Office of the Law Revision Counsel. 15 USC 78m – Periodical and Other Reports