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 who 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.
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 on a regular basis 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 20th December 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 own shareholders.
#3 – Expansion
After being confident about the current product line, 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 shareholder 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 at 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, but 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 financing. Therefore the loan doesn’t give the ownership right, rewards and risks, while capital contribution does.
- Subordination: As for any form of debt financing, the repayment and interest payment for shareholder’s loan happens before the payment is made for equity-holders but after other forms of liabilities while the equity financer only have 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. Dividend on capital contribution is payable only if the company makes a profit or if there are growth opportunities then profits might be plowed back instead of being distributed as dividends.
- Restrictive Covenants: Equity financing doesn’t impose restrictive covenants such as whether the company can take more debt or not or how much dividends can it 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 income.
- 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 it is sanctioned for an indefinite period of time. 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 evasion practices.
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