Borrowing from your own company
If you are a business owner, you probably mix your personal finances with your business finances, meaning you borrow from your business sometimes and repay at your convenience. The balance that you owe to your company should be shown on the balance sheet of your financials as a loan. That’s not enough, though. We need to be extra careful here as the IRS has the authority to re-characterize it as a dividend or distribution, thus taxable to the recipient…and perhaps not deductible to the corporation.
How to protect myself from taxation?
To avoid being taxed on money you borrow from your business, you need to prove to IRS that you do not treat your company as a deep pocket from which you extract funds at will and deposit funds at your convenience. This means that you should enter into a loan agreement with your corporation as if you enter with any other entity, e.g., the bank, so formally document the transaction and pay the interest on your loan.
Having a loan documented and following the payment schedule shows your intention to repay it. Further, charging interest for the loan solidifies the borrowing nature of the transaction.
What interest rate should I pay?
You may not just come up with any interest rate you would like. The least you can pay is the applicable AFR. AFR is the minimum safe-harbor interest rate that must apply to loans between related parties to avoid adverse income or gift-tax consequences – based on the month in which the loan is made, how frequently interest is compounded, and the length or term of the loan. Applicable rates are published every month:
https://apps.irs.gov/app/picklist/list/federalRates.html
Your AFR will vary depending on the loan term:
- Long-term loan – more than 9 years
- Mid-term loan – between 3 and 9 years
- Short-term loan – less than 3 years