Part 3: Loan Docs*
Small, closely held corporations many times prefer to borrow money from their shareholders instead of from a bank. The shareholders may also be actively involved in managing or directing the business, and are usually willing to loan money to the corporation when it needs operating funds, or to make a major purchase, or to shore up the corporation’s cash reserves.
Loans from shareholders, directors, other “insiders” or any other individuals, should always be pre-approved and pre-authorized by the board of directors. The board acts by adopting a formal resolution that is supported with a promissory note containing the terms and conditions of the loan repayment, and any security agreement for pledged collateral.
Having the proper “loan docs” in your corporate records book may help you favorably survive a challenge by a revenue agent when he audits your corporation and decides to look closely at loans it has made or received. Which he will.
Perhaps as important, having complete loan records can help diffuse future disputes and flawed recollections of the nature and terms of the transaction. Oftentimes the borrower and lender have different notions about the loan terms, so having a written record can settle the matter, especially when the parties to the transaction signed the original paperwork. The old adage is appropriate here: “The palest ink is better than the best memory.” Or: “An oral agreement isn’t worth the paper its written on.”
Documentation is Essential
Properly documenting “insider” (i.e. shareholders, directors and officers) loans is an essential part of corporate governance. As such, each loan transaction should be documented with a corporate resolution, promissory note and any other pertinent supporting material.
For example, consider a small closely held corporation where a shareholder is also a director or officer. This “insider” might occasionally lend money to the corporation to cover its immediate expenses or to make a purchase by writing a personal check to the company. Later, the company repays the insider with a corporate check. If there is no formal resolution where the board specifically authorized and approved this loan, and there is no promissory note or other supporting loan docs, a judge or a revenue agent could decide the corporation is actually the shareholder’s alter ego. In that case, the insider could be held personally liable for other corporate debts or obligations that a corporate creditor (spelled: plaintiff’s attorney) might sue over.
Further, without board resolve and supporting documentation, a revenue agent auditing the corporation OR the shareholder would be free to treat such loan transactions as unreported corporate profits that were not properly declared and taxed to the corporation. In that case, add in statutory fines, penalties and interest that will also be assessed to the corporation.
Then, those “loan repayments” could be reclassified as unreported corporate dividend income paid to the shareholder. In that case, add in statutory fines, penalties and interest that will be assessed to the shareholder.
Double whammy.
In the case of repeated undocumented loans like this, a plaintiff’s attorney, a judge, and the revenuer would likely describe this as a behavioral “pattern” that favors a ruling for the plaintiff, a judgement for the creditor, and an audit determination against the taxpayers (meaning, against the corporation AND shareholder).
Dan’s Axiom: The revenuer’s job is not to check your arithmetic; it is to collect more revenue. Give him any reason and that is exactly what he will certainly do.
Essential Documentation
Corporate debt is not equity. Repayment of a loan is not income; it is a return of principal. Therefore, debt should be properly documented as such. At a minimum, the corporate records book should contain a resolution from the board of directors authorizing the specific loan, terms and agreement, and a promissory note in favor of the lender (especially if the lender is a company “insider”), executed by an officer duly authorized and directed (by resolution) to act on behalf of the corporation as borrower.
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*This is the third installment in a series of four posts that focus mainly on loans that “insiders” give to or get from their corporations. The information is not exhaustive, but hopefully it will help you better understand general principals to consider when dealing or self-dealing with your small, closely held business company or incorporated professional practice. My posts are not offered or intended as legal or tax advice. For that, always consult a qualified licensed legal or tax advisor, or both. If you read this first, you may be better able to discuss this subject with your professional advisors.
See also:
Insider Loans Part 1: Conflicts of Interest