Loan to S Corporation Shareholder

[Maria]

Hello, this comes up again. Last tax season when I prepared this 06 S corp. return I had to reclassify $81,000 from distribution to Loan to shareholder, which is an asset on the S corp. balance sheet, I also accrued interest at 5% ($1,750), which makes the loan balance to become $82,750. By the way, the $1,750 was recorded as interest income on the S corp. book but a M-1 adjustment on the tax return so the $1,750 did not flow through to the shareholder as interest income (cash basis). I am preparing 07 return and will reclassify $27,000 from loan to distribution. My question is,

1. Out of the $27,000, should I record:

Debit Credit
Distribution 27,000
Loan to Shareholder $27,000

Or should I credit a portion to loan to shareholder and a portion as interest income. What is the method.

Also, assuming they are paying back the whole amount of the loan, should they pay $81,000 or $82,750? So the $1,750 is interest income to them and then interest expense directly against the K-1. So the net effect is 0??? But why are we doing this to begin with?

This always confuses me. Thank you in advance for your advice.

[Maria]

It is to avoid negative basis

Hi, the reason we reclassified distribution to loan was to avoid negative basis. Thanks.

[BOB W]

Hi, the reason we reclassified distribution to loan was to avoid negative basis. Thanks.

Negative basis could mean taxable income to shareholder(s) if brought about by excess distributions. Not to mention "Loan FROM shareholder" being reduced when it was used as a basis for previous losses.

Which brings up Shareholder Basis Worksheet. I do it for all clients, is it required?

[veritas]

You should not

have backed out the interest of $1750 as an M-1 adjustment. It does not matter the shareholder is on the cash basis, that's the price he pays for taking out too much money.

[dsi]

Maria, I hope you are doing this with your client's approval? Otherwise, you should report the facts as they stand. One of my competitors was doing this every year to certain of his s-corp clients until one day it came back to bite him. He was sued, and had no E&O insurance. That's right, he had to re-fi his house to pay over $10,000 to his client.

[Maria]

Thanks for the Input

I was concerned that when the clients see they have such huge interest income they might wonder why. But since we also prepare their personal returns we will back the interest income out by interest expense. It just doesn't make sense to me since doing so much means doing nothing.

My boss told me that they are aware of what we are doing. I think when they come to pick up the return we will discuss this with them again. Thanks everybody and happy tax season!

[veritas]

What expense?

Where is there an interest expense?

[Maria]

Interest Expense

Interest expense is on the personal level. Shareholders borrowed $ from the S corp. The S corp. has interest income, shareholders have interest expense. I was told that the interest expense directly reduces interest income on the K-1 so the net effect of those interest income v.s. interest expense is zero. Is this correct?

[dsi]

I haven't researched this, but I believe the interest paid to the s-corp by the S/H is personal in nature, and therefore not deductible by the S/H?

[veritas]

You must use

tracing rules.

I doubt very much since the loan originated from excess distributions which is personal in nature, you will have any deductible interest paid by the shareholder. Secondly it did not sound to me that the shareholder made any payments towards the loan so no deduction anyway.

[Maria]

Doesn't sound right

I agree it is personal loan, it does not make sense that the interest expense go directly reduce their K-1 income. On the other hand, doesn't it sound stranger that they pay themselves interest income assuming they make payments to the S corp.

[veritas]

There is no interest expense

for the corporation. The only thing that should show up is interest income on the K-1 for $1,750.

[Auto]

s corp shareholder loan cash basis

If the S corp is on a cash basis, and the shareholder is on a cash basis, and no interest has actually been paid or received on this shareholder loan. So does it get recorded anywhere?

I found in Pub 535, section 4 on Interest Expense, Page 11 "Exceptions for loans without significant tax effect".

I see no tax effect here for two reasons. One, it is a wash, two, no interest has actually been paid.

Can anyone tell me if I still have to accrue interest on the S Corp level?