The C Corporation is a legal entity most small business owners overlook. Depending on your personal circumstance it might be the most tax beneficial entity for you. In this article I look at how to treat shareholders contribution in a corporation.

Capital contributions

A corporation could receive money from shareholders either in exchange of stock or as an additional price paid for existing stock. When money or property is received in exchange of stock neither gain or loss is recognized by the corporation. Moreover, the gross income of the corporation does not include shareholders contributions.

In the same way, additional money received as pro rata transfers do not increase the income of the corporation. When shareholders elect to receive additional funds with no exchange in stock, the contributions represent an additional price paid for the existing shares. The contribution increases the operating capital of the corporation.

Basis of capital contributions

The basis of property received from shareholder as capital contribution is the same as the basis of the property when it was owned by the shareholder. Adjustments are made if the property donated is a loss property.

Debt funding in a corporation

Sometimes, shareholders might choose not to contribute their money as equity but rather fund the business with debt. If debt is chosen as an instrument of funding, care has to be taken to document the agreement formerly. Like equity funding, debt funding is not considered income to the corporation.

The advantage of debt over stock is interest on debt is deductible by the corporation, while dividend payments are not.

On the shareholder side, the loan repayments are not taxable to the shareholders unless the payment exceed basis. Furthermore, dividends are taxed at a lower rate when compared to interest payments.

Reclassification of debt as equity

If a corporation is thinly capitalized, the IRS can re-categorize debt as equity. U.S. Code § 385 – Treatment of certain interests in corporations as stock or indebtedness lists several factors that may be used to determine if a debtor creditor relationship exists. Some factors to consider are:

• Is the debt instrument in proper form? If you have a revolving debt account with no formal documentation, your contributions are more likely to be treated as capital contributions rather than debt.
• Is there a reasonable rate of interest?
• Is the debt paid on a timely basis?
• Are debt payments dependent on earnings?
• Is the debt treated equally with other debt in the corporation?

In summary, debt and equity are two ways to fund a corporation. An equity investor carries greater risks in that there is no guarantee of ever getting your investment back. As an equity investor, you are the last to get paid if the business fails. Even though debt funding carries its own risk, it is less than the risks borne by equity investors.

Lastly, due to the tax benefits of loans, there are sometimes more desirable but care should be taken to follow a formal process.

As allows consult your Certified Public Accountant for more specific advice.