Shareholder Loans – The Real McCoy

As part of the appraisal process, the value of a shareholder loan is considered, which oftentimes leads to these loans being adjusted. Back in college, accounting 101 instructed us on the treatment of loans. Loans owed to the company are assets and loans owed to the shareholder are liabilities. Simple, right? Not so fast. Shareholder loans in private companies can be complex and take on characteristics of compensation, debt obligations or equity. Private companies frequently advance money to owners or vice versa, to bridge cash flow gaps or fund large or unexpected business and personal purchases. Most commonly, owners borrow money from the company as a way to withdraw tax-free cash.

What makes a loan to or from a shareholder a bona fide debt obligation versus a disguised form of equity? The distinction is relevant when valuing a private company, especially in matters of litigation.

During legal proceedings, estranged spouses or business partners may become emotional and even malicious, hiding assets and withholding or manipulating information. Behaviors such as these can compromise the accuracy of the appraisal.

Whether or not a disbursement to or from a shareholder will be considered a loan depends on the actual intent of the transaction. As a starting point, valuation experts often turn to the IRS rules for objective guidance on this matter.

IRS stance

For loans of more than $10,000, the IRS requires taxpayers to treat the transaction as a legitimate debt; therefore, the company must charge the shareholder an “adequate” rate of interest. The IRS publishes monthly applicable federal rates (AFRs), which vary depending on the term of the loan. These rates are the minimum that the IRS considers in determining if the transactions are bona fide loans.

6 factors

IRS considers the following factors when deciding whether payments made to shareholders qualify as bona fide loans:

  1. Earnings and dividend-paying history,
  2. Loan repayment history,
  3. Loan size,
  4. Provisions in the shareholders’ agreement about limits on amounts that can be advanced to owners,
  5. The shareholder’s ability to repay the loan, based on his or her annual compensation, and
  6. The shareholder’s level of control over the company’s decision making.

The IRS also asks to see an executed a formal, written note that specifies the repayment terms, such as the interest rate, a maturity date, any collateral pledged and a repayment schedule.

Valuation connection

In some cases, business valuation professionals may decide it’s appropriate to reclassify a note to or from a shareholder, due to the way management has treated the transaction.

In a marital dispute, the distinction may be significant, depending on the size of the transaction and when an asset was acquired or debt was incurred.

The proper classification comes down to the actions and intentions of the shareholder. The following questions go beyond the IRS guidance and can aid in the demonstration of intent.

  • In a stock sale would the new buyer be responsible to pay the loan?
  • Did the shareholder provide security for the loan?
  • Is there a repayment schedule and was it followed?
  • Would the transaction have occurred if the litigation was not pending?

Debt or equity?

The classification of shareholder loans as equity or debt can potentially have a material impact on the overall value of the subject company. Deciding whether transactions between a company and its owners qualify as debt or equity can be somewhat subjective. The IRS guidance outlines some objective considerations that can be used to support the appraiser’s decision; however, the ultimate decision should be based upon the actions and intentions of the shareholder.

About the Authors

Bryant D. Petersen
Bryant D. Petersen
Director, Valuation/Litigation Support Services


Stay up-to-date with the latest news and information delivered to your inbox.

Subscribe Now