Shareholder Loan - Reasonable Interest

[JohnH]

Sole shareholder of a C-corporation owes the corp about $250K and renews the unsecured note annually with an interest rate reset. What would be a reasonable interest rate for the corp to charge the shareholder for 2009 and 2010?

I'm thinking that with 30-yr home mortgage rates currently in the 4.75% range and ARMS being in the 3.5% range, a 3%-4% rate might be reasonable. Anyone have any thoughts on this either way? Thanks.

[Burke]

Since this is essentially a demand, short-term note (one-year) what about the federal APR rates? As an unsecured note, I would think the rate should/would be higher than on a mortgage where the property is collateral. See Section 7872(e)(2) for annual rates for demand loans between corp and corp shareholders.

[JohnH]

I like that suggestion, especially since the Blended Annual Rate for 2008 is 2.80%, 2009 is 0.82%, and for 2010 is 0.59%. Looks like my initial thought on rates may be very high. I go back & forth on the "unsecured" vs "secured" question. Legally it's definitely unsecured, but I think from a practical standpoint it can be argued both ways.

[Burke]

I like that suggestion, especially since the Blended Annual Rate for 2008 is 2.80%, 2009 is 0.82%, and for 2010 is 0.59%. Looks like my initial thought on rates may be very high. I go back & forth on the "unsecured" vs "secured" question. Legally it's definitely unsecured, but I think from a practical standpoint it can be argued both ways.

I would be interested in hearing your thoughts on the secured vs unsecured rationale. And I too was surprised at how low those rates are. For others' information and reference, see www.evans-legal.com/dan/blended.html.

[JohnH]

Facts & circumstances, I suppose. As we both stated, legally it's unsecured. However, walking away from this debt would not be quite the same as walking away from an unsecured third-party debt for many business owners.

For example, if the shareholder owns the building housing the business, and especially if he's dependent upon the rental income from the business to pay the mortgage on the building, then he can't just shut the business down at will. Not to mention that he would lose his livelihood by shutting it down. So there's an imperative to keep the business operating & healthy for reasons unrelated to the loan itself.

As long as the business is operating, his loan remains in place since it would be illogical for an operating company to simply ignore the debt if he defaulted (and I'm sure IRS would see that as either a constructive dividend or forgiveness of debt income.) All these seemingly unrelated facts are intertwined to lock the owner into an overarching situation that wouldn't exist if it were simply unsecured credit card debt or a signature loan.

Kinda choppy & off-the-top-of-my-head reasoning, but that's the gist of it. Same reasoning might apply even without the building ownership in many situations. Maybe a business with a lengthy history & goodwill to protect, one engaged in professional services, or a business with specialized equipment or expertise. Might not apply to a small service business, but then it would be unlikely to accumulate a loan of this size anyhow.