A shareholder loan is a formal debt arrangement between a corporation and one of its owners: money moves in one direction with a written obligation to pay it back, rather than being contributed as equity or handed out as a dividend. Small businesses use these transfers to smooth cash flow without going to a bank, but the IRS looks at them closely. If the paperwork, interest rate, and repayment behavior don’t hold up, the “loan” gets reclassified — and what was supposed to be a tax-free transfer becomes taxable income.
How the Money Can Move
A shareholder loan can go either direction, and the accounting mirrors that.
When an owner puts money into the company, the corporation records the amount as a liability on its balance sheet, typically labeled “Loan from Shareholder.”1Internal Revenue Service. LB&I Concept Unit – Valid Shareholder Debt Owed by S Corporation Many small businesses run these balances on a revolving basis: the owner puts cash in during slow months and takes repayments in profitable ones. Keeping the money classified as debt rather than permanent equity matters for tax treatment and for the owner’s position if the business runs into trouble.
Cash can also flow the other way, with the corporation lending to a shareholder. This is different from a salary or a distribution because the shareholder doesn’t own the money outright — they owe it back, and the corporation books the amount as a receivable. Documenting the transfer as a loan keeps it from being treated as taxable compensation or a distribution when the shareholder receives it.2Internal Revenue Service. Paying Yourself
One limitation cuts against shareholders on the borrowing side: interest a shareholder pays on a personal loan from their corporation is generally not deductible on the individual return, because it counts as personal interest.3Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest The interest becomes deductible only if the borrowed funds were used for something like a trade or business expense or a qualifying investment.
What Makes It a Real Loan to the IRS
The IRS and the courts weigh several factors to decide whether a transfer is genuine debt or something dressed up to look like it. No single factor is decisive, but the more of them the arrangement satisfies, the stronger the case that it should be respected as a loan.4Internal Revenue Service. Memorandum – Debt-Equity Analysis
Written Promissory Note
A promissory note should be signed before any money moves. It needs the principal, a repayment schedule, a fixed maturity date, a stated interest rate, and default terms.1Internal Revenue Service. LB&I Concept Unit – Valid Shareholder Debt Owed by S Corporation Vague language like “repay when the company can afford it” undermines the whole arrangement.
Board Authorization
The board should formally approve the loan and record it in minutes or a resolution documenting the terms. That record shows the company’s leadership treated the transaction as a real, commercially reasonable loan rather than the owner simply moving money around.
Actual Repayments
The parties have to follow the terms. A note that sits on the books for years with no payments looks like something other than debt, and the IRS reads it that way.1Internal Revenue Service. LB&I Concept Unit – Valid Shareholder Debt Owed by S Corporation
Other Factors That Move the Needle
Reviewers also look at whether the corporation is thinly capitalized (a lot of debt against very little equity), whether every shareholder lent money in proportion to their ownership (which looks like equity), whether a normal outside lender would have made a similar loan, whether the funds were used for long-term capital assets rather than working capital, and whether the shareholder’s claim is subordinated to other creditors. Each of those points toward equity rather than debt.
Interest Rate Rules and the AFR
A shareholder loan has to charge at least the Applicable Federal Rate, which the IRS publishes each month. If it charges less — or nothing — the below-market loan rules under IRC Section 7872 apply.5Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Under those rules, the IRS pretends the lender received interest at the AFR even when nothing was actually paid. For a loan from a corporation to a shareholder, the gap between the AFR and what was charged (the “forgone interest”) is treated as a distribution from the company to the shareholder, then a payment of interest back to the company. Both sides can end up with tax on interest that never changed hands.5Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Which AFR applies depends on how the loan is structured. Demand loans, callable at any time, use the federal short-term rate for each period the loan is outstanding. Term loans with a fixed repayment date use the rate in effect the day the loan was made: short-term for three years or less, mid-term for over three but not more than nine, and long-term for over nine years. For January 2026, the annual-compounding AFRs are 3.63% short-term, 3.81% mid-term, and 4.63% long-term.6Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates
The $10,000 Exception
If the total balance of loans between the corporation and the shareholder stays at or below $10,000, the Section 7872 rules don’t apply and the loan can be interest-free. The exception disappears if a principal purpose of the arrangement is tax avoidance. A separate $100,000 exception exists for gift loans between individuals, but it does not cover corporation-shareholder loans.7Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
What Happens If the IRS Reclassifies the Loan
When the IRS decides a purported loan isn’t real debt, the consequences depend on which direction the money went.
If the corporation lent to the shareholder, the transfer usually becomes a constructive dividend — a distribution of corporate earnings the shareholder has to report as income.2Internal Revenue Service. Paying Yourself The corporation also loses any interest deduction it was claiming on the “loan.”4Internal Revenue Service. Memorandum – Debt-Equity Analysis Sometimes the IRS treats the transfer as unreported compensation instead, which adds employment taxes on top of the income tax.
If the shareholder lent to the corporation and the IRS reclassifies it, the transfer becomes a capital contribution. The corporation can no longer deduct interest, and the money is treated as additional equity rather than a loan the shareholder can recover as a repayment. That difference is especially painful for S-corporation shareholders, whose ability to deduct business losses depends on having debt basis.
Why This Matters More for S Corporations
S-corporation shareholders can deduct their share of business losses only up to their combined stock basis and debt basis — and debt basis exists only when the shareholder has personally lent money to the corporation.8Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders Losses beyond that combined figure aren’t lost; they carry forward until there’s enough basis to absorb them.
A few points shape how this works in practice. Only direct loans create debt basis: guaranteeing a bank loan to the corporation doesn’t count, even when the shareholder is personally on the hook, unless and until the shareholder actually makes a payment on the guarantee. Losses reduce debt basis, and if the corporation later repays the reduced-basis portion of the loan, that repayment is taxable to the shareholder as income.9Internal Revenue Service. S Corporation Stock and Debt Basis Debt basis can be restored in a later year when income items exceed loss and deduction items, but only up to the loan’s original face value.10Internal Revenue Service. Instructions for Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations
Some shareholders try to build debt basis by borrowing from a related entity they own and then relending the money to their S corporation. These back-to-back loans can work, but only if the S corporation genuinely owes the shareholder rather than the related entity. If the S corporation’s books show a payable to the related entity, or the related entity’s books show a receivable from the S corporation, the shareholder probably doesn’t have valid debt basis.1Internal Revenue Service. LB&I Concept Unit – Valid Shareholder Debt Owed by S Corporation
S-corporation shareholders have to file Form 7203 with their individual return in any year they claim a loss deduction, take a non-dividend distribution, dispose of stock, or receive a loan repayment.10Internal Revenue Service. Instructions for Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations Keeping the form current every year, even when it isn’t required, makes basis tracking much easier.
When a Loan Is Forgiven or Goes Bad
If a shareholder forgives a debt the corporation owes, IRC Section 108(e)(6) treats the forgiveness as a contribution to capital. The corporation is treated as if it repaid the debt with cash equal to the shareholder’s adjusted basis in the loan.11Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness If the debt’s face value is higher than the shareholder’s adjusted basis — common when an S-corporation shareholder has already used debt basis to absorb losses — the corporation recognizes cancellation-of-debt income on the difference.
When the corporation can’t pay and the debt is worthless, the shareholder may be able to claim a bad debt deduction. That requires showing the transaction was intended as a loan rather than a gift, that the debt was closely tied to a trade or business when it went bad, and that reasonable collection efforts were made.12Internal Revenue Service. Topic No. 453 – Bad Debt Deduction The deduction is available only in the year the debt actually becomes worthless. Claim it too early or too late and it’s gone.
How to Report It on Tax Returns
Corporations report shareholder loans on Schedule L of their return. On Form 1120-S, loans from shareholders to the corporation go on Line 19, and loans from the corporation to shareholders go on Line 7.1Internal Revenue Service. LB&I Concept Unit – Valid Shareholder Debt Owed by S Corporation C corporations use the same schedule format on Form 1120, with interest expense on Line 18. The Section 7872 rules can require imputed interest to be reported even when no cash interest actually changed hands.13Internal Revenue Service. Instructions for Form 1120 On the individual side, interest received or imputed from the corporation is ordinary income, and S-corporation shareholders who have used loan basis to absorb losses should attach Form 7203 to track their debt basis.10Internal Revenue Service. Instructions for Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations