Q: I recently formed a small S-corporation, which may become the vehicle for an acquisition. Prior to a transaction, the costs of the search process will be more than the very small amount of equity I contributed, so I intend to make shareholder loans as needed to cover cash flows.
Since I am the sole shareholder and the corporate results will flow into my personal tax return, does it matter what interest rate, if any, I charge the corporation for loans? It would be easier administratively to charge zero, and if some rate is charged it would seem that equal amounts of interest income and expense would flow to my return, but I received some advice that you have to charge a rate specified by the IRS. Your thoughts?
A: You are correct in thinking that any interest paid by the corporation would equal the interest you must report as income on your individual return, so in effect they would cancel each other out. However, under Internal Revenue Code Section 7872, the corporation is required to pay interest on the loan(s) you make to it.
The interest rate charged must be at least as much as the applicable federal rate, which is determined monthly by the IRS and posted on the IRS Web site, www.irs.gov. For loans made in April 2001, for example, the rates range from 4.63% to 5.43%, depending upon the length of the loan. There is an exception if the loan balance is less than $10,000. In that case, no interest is required.
If there is no stated interest in the loan agreement, both the borrower and lender, on their tax returns, impute the interest and treat it as if it were paid. In other words, part of the loan payment will be treated as interest expense or interest income. The interest the corporation pays is deducted on Form 1120-S as an ordinary and necessary business expense, thus reducing the corporation's taxable income.
Cindy Hockenberry, enrolled agent
National Association of Tax Practitioners
Editor's note: While the information in Tax Adviser represents the opinion of an expert, it is not legally binding.
Do you have a small-business tax question? Tax professionals will answer your questions in the Tax Adviser column, appearing here Wednesdays. E-mail Taxadviser@businessweek.com. We will not print your name, address or phone number, but please provide this information.