Taking Money Out: Loans From Your Own Company
There is a pitch, and you will meet it: borrow from your own corporation instead of taking salary or dividends, charge yourself the minimum interest the Code requires, amortize over forty years, collateralize with a cash-value insurance product, and access the money tax-free. Every element of that sentence is wrong in a specific and expensive way. The underlying transaction — a genuine loan between a shareholder and a closely held corporation — is perfectly legal and sometimes sensible. The packaged version is a set of choices that maximize the damage.
First, is it a loan at all? The threshold question is an intent at the moment of transfer: did you unconditionally intend to repay, and did the corporation unconditionally intend to compel repayment? Courts scrutinize this hard between related parties, this is your burden, and book entries do not settle it — a withdrawal labeled “note receivable” is still a distribution if the facts say so. The factors the IRS actually weighs are the ones a real lender would care about: how completely you control the corporation, its earnings and dividend history, the size of the advances and whether any ceiling caps them, whether a note exists, whether interest is charged and paid, whether there is security, whether there is a fixed maturity, whether the corporation has ever tried to collect, whether you could plausibly repay, and whether you have made any attempt to. No single factor decides it. Two patterns are close to fatal: a balance that grows year over year, and a note reissued annually for the old balance plus accrued interest, which shows a maturity date that means nothing.
Note the sequencing, because it determines how bad the failure is. The below-market-interest rules discussed below presuppose that a loan exists. If the arrangement is not bona fide, those rules never engage and the entire principal is a distribution. Imputed interest is what you get if you win the first argument.
What failure costs, which depends on the entity. For a C corporation the withdrawal becomes a IRC §301d, “Distributions of property”istribution: a dividend to the extent of earnings and profits under IRC §316, then a return of capital against stock basis, then gain. The corporation gets no deduction — there is no provision granting one, and IRC §162(a)(1) reaches only reasonable compensation. So the money bears the corporate rate and then the shareholder’s dividend rate plus the 3.8% NIIT. For an S corporation, IRC §1368(b) makes it a distribution that is tax-free against stock basis and capital gain above it, with a waterfall through the accumulated adjustments account under IRC §1368(c) if the company carries accumulated E&P from prior C years.
The failure mode that actually hurts an S corporation is different and worse: recharacterization as wages. Where an owner-employee has been undercompensated, the examiner asks the reasonable compensation question first (section “Reasonable Compensation and the Break-Even Point”) and tests the loan only on the residue. The bill is both halves of FICA and Medicare, the additional Medicare tax, failure to deposit, failure to file and pay, the trust fund recovery penalty reaching responsible persons personally, and the accuracy-related penalty. Reduced substitute rates exist for misclassification, but they are unavailable where the failure is due to intentional disregard — and a documented scheme built to avoid payroll tax is precisely what makes intentional disregard arguable.
The interest rule, and why forty years is the worst possible term. IRC §7872c, “Treatment of loans with below-market interest rates”overs corporation-shareholder loans directly. The demand-versus-term machinery is laid out in full at section “Lending to Friends and Family: Navigating the Financial and Emotional Minefield”; what follows is how it lands on a shareholder, and it turns on a distinction the pitch ignores. A demand loan produces forgone interest imputed annually, referenced to the short-term AFR, deemed transferred to you and handed back as interest each December. A term loan is far harsher: IRC §7872(b) treats the lender as transferring, on the day the loan is made, the excess of the amount loaned over the present value of the required payments. That is one immediate, front-loaded deemed distribution, not an annual drip. And IRC §1274(d) picks the rate by term — short-term to three years, mid-term to nine, long-term beyond.
Put those together and the forty-year structure is the worst available on both axes: it forces the long-term AFR, the highest of the three, and it maximizes the day-one hit if you shade the rate at all. On a $1,000,000 forty-year interest-only note at a long-term AFR near 5%, stating no interest produces a deemed distribution on day one of roughly $850,000. Stating 1% still produces about $680,000. A forty-year repayment horizon also destroys the bona fide analysis independently, by making the maturity meaningless and repayment contingent on events decades away.
Charging the AFR exactly avoids IRC §7872 — but then you must pay real cash interest, the corporation reports it as taxable income, and your side is generally nondeductible personal interest under IRC §163(h), unless the proceeds trace to a business or investment use (section “Interest Tracing: How Loan Use Determines Deductibility”). There is no version of this that is free. The de minimis exception is $10,000 of aggregate loans between the parties, and it is lost entirely if tax avoidance is a principal purpose of the interest arrangement. People cite a $100,000 exception here; that one is a gift-loan rule between individuals and does not apply.
The collateral leg is separately fatal. Pledging a cash-value insurance product to secure the loan fails twice over. IRC §264(a)(4) disallows interest on debt with respect to life insurance, endowment, or annuity contracts the taxpayer owns, outside a narrow key-person exception capped at $50,000 of indebtedness. And if the collateral is genuinely an annuity, IRC §72(e)(4)(A) treats pledging or assigning it as a taxable distribution in its own right — the relief that spares ordinary life insurance policy loans does not extend to annuity contracts, and a 10% additional tax may follow. “Whole life annuity” is not a product; whichever half is real, the structure loses.
The S-corporation basis trap, stated flatly. Direction is everything, and this is the error the promoter version reliably makes. A loan from you to your S corporation creates debt basis that absorbs pass-through losses under IRC §1366(d)(1)(B), provided it is bona fide indebtedness running directly to you — a guarantee does not count until you actually pay. A loan from the corporation to you is a corporate asset and creates zero basis. Worse, if that receivable is later recharacterized as a distribution and you are basis-poor, the excess is capital gain: you pay tax on cash you had booked as a liability.
If you do it anyway, do it properly. If you genuinely need a shareholder loan, treat it with the formality a commercial lender would demand. Execute a formal promissory note at the time of the transfer with a fixed maturity date, and never roll the balance annually into a new note. Charge stated interest at or above the applicable AFR for the loan’s term, published monthly by the IRS. Make actual, scheduled cash payments from your personal funds so the principal balance visibly amortizes. Secure the note with collateral where feasible, adopt a formal board resolution authorizing the loan with a clear borrowing cap, and document your financial ability to repay at the moment the funds are disbursed. Treat the loan consistently across corporate and personal tax returns — remembering that once you declare a transfer as a loan, the tax law’s duty of consistency bars you from retroactively reclassifying it as a dividend when convenient. Finally, ensure the corporation actually enforces the terms if a payment is missed. If the arrangement cannot meet these standards, it is not a loan, and the label it takes instead is not your choice — a dividend out of a C corporation, a basis-reducing distribution or wages out of an S corporation.