Navigating Bona Fide Loans Between Shareholders and Their Companies

Document showing a bona fide loan agreemend.

Shareholders are among the most invested people in a business. This is because the financial excellence of the business often has direct benefits for the shareholder. But, sometimes a business may need financial help and this is where bona fide loans become relevant.

A bona fide loan is one in which the shareholder lends the funds to the company. This could take place for various reasons that include funding expansion, meeting financial obligations, or taking advantage of business opportunities. But, there are legal and tax compliance considerations that come into play with bona fide loans. Our CPAs have helped many shareholder-companies structure these loans for compliance and and fostering positive relationships between shareholders and their companies. In this article we take a look at some of the legal and financial intricacies of these loans and why it’s crucial to tread carefully to avoid potential tax and legal complications.

Defining a bona fide loan in a business context

It is important to distinguish between a bona fide loan and other financial arrangements, such as dividends or contributions. This is to to maintain legal clarity, prevent potential tax and compliance issues, and ensure transparent financial transactions within the shareholder-company relationship.

A bona fide loan emphasizes a formal lending agreement with an obligation for repayment, including interest. Dividends and contributions involve the distribution or injection of capital without the expectation of reimbursement. Each have distinct tax and legal implications.

Legal requirements for bona fide loans

With bona fide loans the loan agreement must be formalized with necessary documentation and ensuring compliance with applicable federal and state laws such as the Truth in Lending Act (TILA) as well as the Uniform Commercial Code (UCC), and more.

Our CPAs advise including some of the following formal loan agreement necessities when formalizing a bona fide loan:

  • Identify the parties: Clearly identify the parties involved – the lender (shareholder) and the borrower (company) – including their legal names and addresses.
  • Loan amount and purpose: Specify the exact amount of the loan and the purpose for which it is being granted. This provides clarity on the intended use of funds.
  • Interest rates and terms: Define the interest rates, repayment terms, and any conditions for changes in these terms. Include details about the frequency of payments.
  • Repayment schedule: Outline a detailed repayment schedule, specifying due dates, the amount of each installment, and any penalties for late payments.
  • Collateral and security: If applicable, detail any collateral offered by the borrower to secure the loan. Clearly describe the rights and obligations related to the collateral.
  • Default and remedies: Clearly state the conditions under which the loan is considered in default and outline the remedies available to the lender in such cases.
  • Governing law: Specify the jurisdiction and governing law that will apply to the agreement. This is particularly important for cross-border transactions.
  • Confidentiality: Include provisions regarding the confidentiality of the loan agreement and related financial information to protect sensitive business information.

IRS guidelines when it comes to establishing interest rates 

Setting an appropriate interest rate is not merely a financial consideration. You also need to consider the legal bounds within which to do so. Adhering to IRS guidelines, particularly the Applicable Federal Rates (AFR), is crucial to avoiding repercussions associated with below-market interest rates and ensuring the financial health of both parties involved.

The Applicable Federal Rates (AFR), issued monthly by the Internal Revenue Service (IRS), comprises of short-term,  mid-term, and long-Term AFRs. It is important to consult with your CPA when setting up your loan agreement as these rates set the standard for fair market interest rates, and in so doing,  helps to prevent tax evasion. Ultimately, adherence to AFR promotes compliance, transparency, and the integrity of financial transactions in various scenarios. It is greatly advised to work alongside your CPA in this regard.

Tax implications and reporting requirements

Bona fide loans can have several tax implications for both the lender (shareholder) and the borrower (company). Here are some key considerations:

  • Interest deductibility: The interest paid on bona fide loans is typically tax-deductible for the borrowing company. This deduction can reduce the company’s taxable income, providing a potential tax benefit.
  • Taxable income for lender: The interest income received by the shareholder as part of the bona fide loan agreement is generally considered taxable income. The lender must report this interest income on their tax return.
  • Imputed interest rules: If the interest rate charged on the bona fide loan is below the Applicable Federal Rates (AFR) set by the IRS, imputed interest rules may come into play. In such cases, the IRS may impute additional interest income for tax purposes. This could potentially affect the tax liability of both the company and shareholder.
  • Tax reporting requirements: For tax accuracy and compliance, both the the company and the shareholder must accurately report interest income and deductions on respective tax returns.

Auditing and compliance

Auditing and compliance in the context of bona fide loans are critical components of maintaining financial integrity and legal adherence. Therefore, meticulous record-keeping cannot be overstated, as it serves as a safeguard in the event of an audit. Detailed records of the loan agreement, interest payments, and any amendments provide transparency and demonstrate a commitment to regulation. Non-compliance with IRS regulations in this regard can lead to penalties, interest assessments, and potential challenges in defending the legitimacy of the loan.

Consulting with a CPA in this regard cannot be emphasized enough. This is especially true for S-Corps and C-Corps. As these entities introduce additional layers of complexity when it comes to bona fide loans. Rather get it right from the get-go. If you are considering a bona fide loan, contact us for guidance today!

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This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. We base articles on current or proposed tax rules at the time of writing and do not update older posts for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.