What is Shareholders Loan?
Shareholder’s Loan is a form of financing falling under the debt category, where the source of financing is the shareholders of the company and that is why it is called so, this loan is of subordinate level, wherein the repayment happens after all other liabilities are paid off and even the interest payment is generally deferred as per the terms of the loan indenture.
Explanation
- Shareholders Loan is another form of financing that the companies go for when they are at a very initial stage and can’t afford bank loans or debt financing or may not be getting the same because of anything concrete to show off to the lenders. In such cases, apart from putting in share capital, shareholders also give out loans to the company at fixed interest terms and conditions.
- We can consider it as a hybrid form of financing, but the financing is of debt format. Interest is fixed but deferred. Repayment is subordinated to another debt financing, if any, but should be paid off before profit distribution to shareholders.
- Most times, it is the company that is the borrower; however, at times, it is also the shareholder, who needs to borrow from the company. Although this is not considered as the generic meaning of the term, however, it might be considered as a negative shareholder loan from the perspective of the company.
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Source: Shareholders Loan (wallstreetmojo.com)
How Shareholder’s Loan is Used?
#1 – Working Capital
At times the companies require quick financing for its working capital requirements. For this reason, it may go into a shareholder’s loan format because it needs regularly and that too at a snap of the fingers; otherwise, its day to day operations are hampered. An example being the loan agreement between eBay PRC Holdings (Bvi) Inc. and Tom Online Inc., dated December 20, 2006, as per the archives of SEC.
#2 – Business Operations
At times the purpose of the loan is not specified because there isn’t anyone particular use for the funds. A company might need additional funds, and therefore instead of raising more equity, it prefers debt capital, and therefore instead of going to an outside lender, it asks for the same from its shareholders.
#3 – Expansion
After being confident about the current product lineProduct LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing.read more, a business may want to expand into a new geographical region or may want to add another product line so it might want to raise new funds and shareholder’s loan might be a more suitable option because most times it comes with lower strings attached, that is, the loan period is indefinite or there might be no interest on the same at all. An example being the loan agreement between Kunekt Corporation and Mark Bruk, the sole shareholderShareholderA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more of Kunekt, effective as of October 1, 2007, as per the archives of SEC.
#4 – Debt Refinancing
At times the company wants to pay off an old debt because that it had taken at a higher rate of interest or more restrictive terms and conditions, for this purpose, it requires funds, and therefore it raises a shareholder’s loan, which it might be able to negotiate at a better rate or maybe at the current market rate, which is lower than the old rate. Still, the company doesn’t want to wait longer to go to an external lender.
Shareholder’s Loan vs. Capital Contribution
- Nature: Shareholder’s loan is a form of debt financing, while the capital contribution is equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more. Therefore the loan doesn’t give the ownership right, rewards, and risks, while capital contributionCapital ContributionContributed capital is the amount that shareholders have given to the company for buying their stake and is recorded in the books of accounts as the common stock and additional paid-in capital under the equity section of the company’s balance sheet.read more does.
- Subordination: In any form of debt financing, the repayment and interest payment for shareholder’s loan happens before equity-holders. However, it is after other forms of liabilities. While the equity financer only has the residual right over the assets of the company.
- Return: Interest on the loan is fixed and payable even if the company has losses, although it can be deferred as per the covenants of the loan document. The dividend on capital contribution is payable only if the company makes a profit. If there are growth opportunities, then profits might be plowed back instead of being distributed as dividends.
- Restrictive Covenants:Covenants:Covenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more Equity financing doesn’t impose restrictive covenants such as whether the company can take more debt or not or how much dividends it can payout or whether it can invest in riskier projects or not. However, a loan or debt financing does impose such restrictions.
How does Shareholders Loan Affect Taxes?
- Below market loan:
- When the shareholder’s loan is at an interest rate that is lower than the market rate, or the rate published by the Internal revenue Service (IRS), such a loan is known as a below-market loan.
- The difference between the interest paid and that it should be paid according to the market rate and is considered as an income for the company, and therefore it is taxable.
- However, if the loan amount is $10000 or lower, the interest differential is not taxable.
- In case the shareholder borrows from the company, and if such a loan is repaid within one year, then it is not treated as income for the borrower, and therefore it is not taxed under the ordinary income head. However, if the repayment is delayed, then it has two negative consequences:
- It is taxed to the shareholder as an ordinary incomeOrdinary IncomeOrdinary income refers to an individual's or business entity's earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more.
- The company is not allowed to consider the same as salary, and therefore, it can not expense it to the profit and loss account, and therefore, the tax on the profit is higher. So the same amount is taxed twice, and ultimately the shareholder, who owns the company, is paying this tax twice because it is directly cutting into his profits.
Conclusion
Shareholder’s loan is a quick and more flexible form of financing which the companies might raise if they are not able to afford external debt or if they don’t have the time to do so. Further, it is also cheaper form as at times, no interest is charged, and it acts as a long term cushion when sanctioned for an indefinite period. Both the lender and borrower need to be cautious about its tax consequences and the formalities related to the same because the IRS keeps a close watch on such financing for any form of tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. read more practices.
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