When a principal of an S corporation pays money into the business, vastly different tax consequences exist depending on whether the payment is considered a loan or classified as an additional contribution of paid-in capital. Loan repayments from the S corporation to the principal are generally not considered income to the principal. However, if the initial payment was considered additional paid-in capital, subsequent payments to the principal may be considered dividend distributions or wages, which are then taxable to the principal and may even include self-employment taxes.
For a principal's payment to an S corporation to be properly treated as a loan, the Internal Revenue Service, or IRS, requires a bona fide debt agreement to exist between the S corporation and the principal. If no such agreement exists, the loan may be considered additional paid-in capital by the IRS. Elements of a bona fide debt agreement include items such as:
1) A written agreement or promissory note between the S corporation and the principal
2) A reasonable rate of interest charged on the loan
3) Some type of security for the loan
4) A repayment schedule for the loan
The overarching theme in this determination is a true loan agreement must be put in place in which the lender, who in this case is also a principal, has all the normal protections of an outside lender. If such protections do not exist, the funds could be considered "at risk." This is the same as with any other investment or contribution into a business enterprise. From the perspective of the S corporation, the receipt of the principal's funds should only be classified as debt if a true debt agreement is in place. If not, the funds received should, by default, be recorded as additional paid-in capital.
Since S corporations are flow-through entities, the tax impact of the business' net income or loss is recognized on the individual tax returns of the principals. The principals are responsible for tracking their personal stock basis and debt basis in the business. S corporation pass-through losses can only be deducted up to the amount of basis owned by each principal. Conversely, S corporation pass-through income in excess of basis is considered taxable income. Although the S corporation itself is not responsible for the tracking the stock basis and debt basis of its owners, it should still clearly delineate capital contributions from loans so the year-end financial statements are correct. Any errors in the S corporation's financial statements could cause the K-1s issued to the stock owners to be incorrect. It is also vitally important that clear communication exists between the management of the S corporation and the principal contributing or loaning money to the corporation.