Corporate Advances to the Owner: Loans, Dividends, or Salary?
Understanding the finances of owning a business is critical to your success, as well as your avoidance of serious issues with the IRS. Such is the case with corporate advances. These funds need to be well-documented and properly allocated in order to keep things running smoothly.
There are a few different things to consider when it comes to allocating these funds and properly documenting them. That starts with the type of business that you have.
S and C Corporations
Businesses that operate as S or C corporations must report loans as loans. That means that if the corporation loans you money, or an owner loans money to the corporation, it must be reported as a loan and nothing else.
If you have an S corporation, a loan that isn’t properly filed can result in taxable wages for the owner.
If you have a C corporation, not properly documenting a loan can create taxable dividends for shareholders.
Depending on the circumstances of the situation, the IRS may or may not take a closer look at things when they see corporate advances and similar disbursements on your tax returns and business filings.
What Happens When You Take Advances?
There are several situations in which business owners take corporate advances and it’s totally acceptable. The paperwork must be properly filed and the funds must be clearly documented. If, however, there is any question as to whether the advance may have been used for certain purposes or was intended to be a loan, that could create a red flag that causes the IRS to consider an audit.
To help, let’s take a look at a couple of examples.
Mr. Teymourian
Mr. Teymourian was told by the IRS that he owed more than $600,000 in taxes and penalties. They claimed he received advances from the corporation where he had majority control. Although he took his case to court, and won, he still had to do all the work in the process.
He didn’t realize that the advance account gets a lot of scrutiny. When the IRS looks at this, they typically check for one of two things:
- The advances are loans from the corporation to the owner.
- The advances are being disguised as dividends, which should be taxable to the owner.
While building a home, Mr. Teymourian got some big advances during the project. The paperwork wasn’t quite right, which created issues in the first place. If the paperwork had been accurate, he could have avoided the hassle.
Husband and Wife
In this example, a husband and wife were owners of a corporation. The husband was in charge of running the business and wasn’t very good at the formalities of paying himself. In addition to his weekly pay, he gave himself $100 and took money as needed for personal expenses.
On the books, these were documented as ‘shareholder advances.’ On financial statements, they showed as loans to third parties. And then at the end of each year, the outstanding loan balance was paid by the husband’s year-end bonus.
The husband, of course, tried to argue that the casual way that he handled the funds shouldn’t be penalized because that was how he dealt with the business (informally). However, the IRS audit determined that these weren’t true loans and therefore, made them taxable.
The court wanted proof the husband intended to repay and that the corporation intended to make him do so. Since he couldn’t prove his case, the funds were taxed as constructive dividends.
The court cited the reason that the owner was using his corporation as his own pocket, where he could extract and deposit funds as he saw fit. As a result, he ended up paying a fortune in taxes on money that he could have allocated and accessed differently.
Avoid the Risks
If you want to make sure that you don’t end up in this situation, always consult a financial expert before taking money from the business. Whether you call it a corporate advance, a loan, or anything else, it could mean danger for your tax reporting if you aren’t careful.
To help, make sure that you are paying attention to the formalities when you withdraw money from the business. That includes:
- Making sure the withdrawal is properly documented as a loan with a legally binding and enforceable promissory note.
- Including the loan authorization in corporate minutes for proper documentation.
- Including interest at the relevant federal rate, and using collateral where appropriate.
- Reporting the transaction as a loan in the books and records, including all financial statements.
- Making repayments in accordance with the promissory note.
As in the example above, small repayments over time or full repayment at the end of the year don’t show a true debtor-creditor connection and therefore could compromise the terms of the funds being used.
When in doubt, make sure that you consult your accountant or another financial expert so that you know what you’re getting into. Take the time to learn about how to properly take advances and loans from the company to avoid huge tax assessments and other potential risks.
Final Thoughts
Owning a business is a challenge. The finances of that business are something that requires dedicated time and attention. Many people end up in tax situations they can’t afford because they mishandled or misallocated funds in a business they own. It’s far too easy to do, and a lot of people get away with it without incident.
Unfortunately, the IRS is starting to crack down on this, so corporations need to be even more diligent than ever before in their use and reporting of advances and loans. Not only does it come with tax risks if you don’t, but you could create problems with shareholders, officers, and others in the company.
The bottom line? No matter what you call it, make sure that you’re following protocols when you take money from your corporation. Formalities exist for a reason and can help you avoid the dangers that often come with this process.
