How can you avoid the problems associated with borrowing from family or friends? Dennis J. White, a partner at Sullivan & Worcester, a Boston law firm, urges business owners to clarify the nature of their financing transaction up front. "Is it a straight business loan, a personal loan, a gift, or an equity investment?"
Each transaction promises a unique set of tax consequences and potential complications. For example, if a loan to a new business ultimately proves uncollectible, its lender may be entitled to a tax write-off. In such a case, the bad loan is a "capital" loss that is valuable only to offset capital-gains income. Should a financing structured as an equity investment go bust, the IRS will allow a tax deduction for an "ordinary" loss, in certain circumstances. "Before money passes hands, both parties need to do research to see which type of transaction makes the best sense for their case."
Once you all agree on the nature of the financing, White urges you to draw up formal documents stating all the terms -- including interest charges. "If the lender ever takes a tax loss connected with your company, he or she will need that document to prove it," explains White. Without such a document, "the IRS could step in and characterize the transaction in a way that maximizes taxable income."
How bad can things get? White warns that if the IRS decides that an undocumented loan to your S corporation was a de facto purchase of a second class of stock, "your company could lose its S-corporation status." Moreover, if the IRS decides that a loan to your company was actually a gift to you personally, and if the amount is more than $10,000, the lender can expect to receive a hefty tax bill.