Loans from a Shareholder:
When repayment + IRS = Taxable Dividend

It happens frequently for small corporations. The fiscal year-end arrives and operating capital is needed to get through the next month. Naturally, one or more shareholders make a swing loan to the company.

In fact, it seems so natural, that many small companies skip the written promissory notes and the appropriate corporate resolutions. Generally, the note is repaid and no problem ever arises.

However, if the IRS ever audits the company or the shareholder who loaned money to the corporation, then an avoidable tax nightmare could arise. During the audit, the IRS may take possession of key corporate documents including the corporate minute book. If you're unlucky, this occurs before you update your corporate minutes (perhaps, key directors or shareholders are now unable or unwilling to sign the resolutions).

Absent a signed promissory note and adequate board resolutions (corporate minutes) approving the loan and the repayment, the IRS may characterize the loan money as a contribution of additional capital and the loan repayment as a dividend. A loan repayment is tax deductible by the company and, except for the interest, is not income to the shareholder. On the other hand, a dividend is not tax deductible by the company and is now undeclared income to the shareholder.

The legal effect: (1) the corporation has improperly deducted a "dividend payment" as the payment of loan interest and principal; (2) the corporation will owe back taxes and, perhaps, a tax penalty; (3) the shareholder to whom the loan interest and principal was paid failed to report taxable "dividend" income (the repaid principal) on his or her income tax return; and (4) the shareholder will owe back taxes and, perhaps, a tax penalty.

To avoid this problem: For each shareholder loan execute a written promissory note AND hold a special board of directors and a special shareholders meeting (or execute a separate unanimous written consent of directors and a unanimous written consent of shareholders) to approve resolutions authorizing the corporation to borrow the money and, later, to apporve resolutions authorizing it to repay the loan.