A bonafide “loan” from a shareholder to your company can turn into something much worse should it go unpaid. Even if there is a legitimate loan document detailing the interest, repayment schedule and other characteristics of the loan, it does not mean much when the terms are not enforced. There could be serious consequences as we explain below.
What happens if the loan isn’t repaid?
In these situations, the debt is generally reclassified to equity and any interest deduction taken is disallowed as per the court cases Roth Steel Tube Company v. Commissioner, 800 F2d 625 & Indmar Products Co., Inc., TC Memo 2005-32.
This treatment is recommended for the following reasons:
- The debt will not be repaid
- There’s no history of repayment
- An independent third party would not issue the same debt
What if the debt isn’t reclassified?
If the company does not reclassify the loans to equity, they may face significant penalties as noted in the tax court case of Laidlaw Transportation v. the Commissioner of the IRS. In this case, the company paid large penalties for deducting interest when it should have been treating the loans as equity in the first place. This case is an excellent example of why it’s important for financial controllers & CFOs to ensure that the debt obligations are being met so that they do not need to have the loans reclassified to equity or pay large penalties.