It's not unusual for the owners of privately held companies to borrow money from company coffers,believing the cash is theirs to use without triggering unwanted tax liabilities.
But such shareholder loans are risky. "In the worst-case scenario, the IRS decides that the transaction wasn't a loan, it was a corporate dividend," explainsValerie Robbins, a partner at the Washington, D.C., accounting firm of Beers & Cutler. A dividend payment is taxable to its recipient but provides no taxdeduction for the corporation. The second-worst-case scenario is that the IRS decides the loan was really compensation, which then gives the corporation atax deduction, but means the recipient still owes income and Social Security taxes.
To avoid both tax hits on loans, tax professionals advise taking these four steps:
* Document the loan in writing, with signatures from the recipient and company owner -- two signatures if they are the same person.
* Observe every formality that would accompany any other official document, including getting it witnessed and filing it in the company's corporate records.
* Include a clause that specifies an annual interest rate for the loan -- preferably at least a point above prime.