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Business owners often ask us whether they should contribute (i.e. invest) money in their business or loan money to the business when additional capital is needed. Loans and capital contributions each have distinct characteristics that might make one more attractive than the other for your individual circumstances. Loaning money to your business can be advantageous because (i) it allows you to inject additional capital into the business on a temporary basis during a time of need without increasing your capital contribution, (ii) depending upon the lending terms, the loan can be repaid to you as soon as the additional capital is no longer needed, (iii) loan repayments are distributions that are not subject to tax (other than potential tax on the interest if it reaches a certain threshold), and (iv) loans have a higher priority than equity, meaning if the business is liquidated, then loans are repaid before equity owners receive anything. If you decide to make a loan, then you should understand and be careful to avoid the potentially harsh consequences that can result if the loan is reclassified by the taxing authorities as equity rather than debt.
Loans must be properly documented and accounted for in the records of the business in order to be respected for tax purposes. If your loan lacks proper documentation or is not properly reflected in the records of the business, the Internal Revenue Service ("IRS") and the New Hampshire Department of Revenue Administration ("DRA") may attempt to recharacterize the loan as a capital contribution to the business. If the loan is recharacterized as a capital contribution, then loan repayments will be treated as dividends or other potentially taxable distributions from the business. To compound the problem, the IRS and DRA may also hit you with failure to file and failure to pay penalties as well as interest on the amount of the outstanding tax liability resulting from the recharacterization of the loan. For S-corporations, recharacterization of a loan as a capital contribution may result in the loss of S-corporation status because loan repayments may be deemed impermissible disproportionate distributions.
Assuming the loan is properly documented and accounted for, there is also a risk that if the loan bears too close of a resemblance to equity, it will be recharacterized as a capital contribution. This is more likely to occur if, for example, the business was not adequately capitalized from the outset, loans were made by the owners in the same proportion as their ownership percentages, loans were made on an interest-free basis or the lenders' priority is the same as or very similar to an equity holder.
The IRS and DRA consider a loan to be a bona fide debt obligation if it is a valid and enforceable obligation to pay a fixed or determinable sum of money. There is no bright-line rule with respect to the debt vs. equity analysis and a determination is made based upon the IRS's broad multifactor test. The test takes into account all relevant facts and circumstances that bear upon whether the loan truly constitutes debt rather than equity.
The IRS and DRA will ask the business and the business owner who made the loan to provide documentation sufficient to support the loan. The business owner bears the initial burden of proving that the obligation is properly characterized as debt. Failure to have the proper documentation and recordkeeping in place will likely result in recharacterization of the debt as equity.
In order to ensure that a loan will be treated as debt rather than equity, the business and business owner should do the following:
- Agree upon lending terms that bear the markings of a true debt obligation rather than a disguised equity investment.
- Have the business formally approve the borrowing in accordance with the business' governing documents.
- Memorialize the material terms of the indebtedness in a written agreement signed by the business and the business owner containing all key terms of the borrowing, including the principal or maximum borrowing amount, the interest rate, the duration of the borrowing and the repayment terms.
- Consider collateral to secure the loan.
- Follow the agreed-upon loan terms and make sure the borrowing and repayment are adequately and accurately documented in the business' records.
If you have any questions about whether to make a loan to your business or how to properly document the loan, please feel free to give us a call or send us an email. We are here to help.
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The Devine, Millimet & Branch Small Business Practice Group offers this free E-Mail Alert service to provide information on recent developments in business law. If you have any questions about this e-mail, or if you know of anyone else who may be interested in receiving these alerts, please send us an email at smallbusiness@devinemillimet.com.
This is not a legal document nor is it intended to serve as legal advice or a legal opinion. Devine, Millimet & Branch, Professional Association makes no representations that this is a complete or final description or procedure that would ensure legal compliance and does not intend that the reader should rely on it as such.
© Copyright 2013 Devine Millimet & Branch, Professional Association
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