I read in a book somewhere (that I can't find again) that in a year
when a corporation is very profitable and you expect to have the
corporation need that money in later years, to have the S-Corp loan
money to an officer (stockholder).

My understanding is that the officer/stockholder would provide a
promissory note to the S-Corp with terms and interest payable to the
S-Corp for the loan.  By providing a promissory note and paying
interest it should prevent the IRS from re-classifying the loan as a
distribution.  This is supposed to defer the profits (and associated
individual tax liability flow-through to stockholder on Sch. K) to
later years when the loan is repaid (w/ interest) back to the S-Corp
when the S-Corp needs the money.

My accountant says that a loan to an officer does not affect P/L of
the S-Corp at all.  He says that in effect, it might as well be a
distribution to the stockholder since a loan has no effect on the
income/profit of the corporation.

Why would a S-corporation loan money to an officer and have the
officer pay interest in return if the income that flows through to the
Schedule K of the officer/shareholder has the same effect as a
distribution in that year?  Why would I take a loan from my company
and have to pay it back with interest if it doesn't make any
difference on the flow-through to my Schedule K?  I know corporations
make loans to officers all the time.  Why would this be done if there
was no benefit to the corporation or the officer for doing this?

I need an answer that refers to something in the tax code or from a
credible accounting source to prove how a loan from an S-Corp to an
officer works and how it should be treated by the corporation from a
P/L and Sch. K tax standpoint.

Otherwise I guess I'll have them reclassify the loan to distributions
and save myself the interest payment.

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Clarification of Question by huhwhat-ga on 05 Mar 2005 11:21 PST

I was afraid that was the answer I was going to get.  I know you can
do it for a C-Corp, but unfortunately this is an S-Corp.  We have
"windfall" years and "dry as a bone" years.  If income averaging was
still around it would be a tremendous benefit to our personal tax
returns...but it is gone.

It is so hard to balance the needs of the corporation w/o getting
killed tax-wise (isn't that an oxymoron?) by retained earnings or
distributions flowing through to our personal returns in windfall
years.

The whole tax system is so broken and complicated that I don't think
anyone has all the answers.  Every time you ask the IRS you get a
different answer.  Accountants and CPAs don't agree on everything
either.  I'm constantly having to look things up in the tax code and I
don't have the time or mental fortitude to become an amateur CPA.  I
sure hope some kind of tax reform gets done by the current
administration, but it looks like it will take a long time to fix.

Can anyone give me some good ideas about ways to balance the cash flow
in an S-Corp and not get hammered at year end with all the profits
flowing through on top of my head in good years?

Would it be better to form an LLC, transfer everything from the S-Corp
to the LLC and shut the S-Corp down? Also the S-Corp owns some
commercial real estate (in the corporation's name).  The S-Corp is a
member of other LLCs.  I don't think a LLC can be a member of another
LLC.  I think we are stuck with the S-Corp because of its membership
in other LLCs.

I really need some creative (but legal) help on not taking a tax
beating personally in these windfall years with income flowing through
from Schedule K.

One part of your question.

I know you asked about S, but I never understood why most S
corporations exist, the C corporation has a lot of advantages, still
this comment might help you understand even if it is an S.

C Corporations, especially small ones make loans to officers and vice
versa all the time for various reasons.

One is simply to get money to do something or buy something without
going through the cost and hassle of a regular loan. You can also make
loans at lower interest rates, although you still need to charge
interest.

If it is closely held then the interest paid to the corporation
eventually goes back to the lending officer at least in part and the
corporation saves on the loan rate.

Also, closely held C corporations pay taxes on any profits they are
holding at the end of the fiscal year. One way to avoid this is to
take all the money out of the corporation at the end of the year and
loan money to it to keep operating, then get paid back the following
year.

If the expenses are legitimate there is nothing wrong with it because
it avoids double taxation on the profits and, unless you need to show
a profit to attract stock buyers there is no real reason to show a
profit.

Remember, this is simply a comment, not an answer to your question.

Your accountant is correct.  The 'earnings' of an S Corporation are
taxed, via a flow-through to the owners.  A loan to an officer has no
effect on these earnings (other than any interest that may have been
paid on the note).

Why would one create a loan rather than a distribution.  One reason
might be two conflicting cash needs: 1) the stockholder may need the
money (for personal reasons; buy a house, invest in another business,
etc.) and 2) the business from which the money is drawn is also in
need (or will be in need) of the funds (in the future).

In other words, the intent of such an arrangement is that you can have
this money now, but the business needs it back later (perhaps for
capital expenditures, bank note repayment, or general cash flow
purposes).  It has no tax advantages whatsoever.

If your business does not need the money and you want to extract the
profits, then convert your loan receivable into a distribution and
just take the money (and save yourself the interest).