A loan from a shareholder appears on the balance sheet as a liability: you debit Cash for the money received and credit an account titled “Shareholder Loan Payable” or “Loans from Shareholders.” Whether it sits under current or non-current liabilities depends on when the principal is due. The bookkeeping is the simple part. The work that actually protects the entry is structuring the loan so the IRS treats it as genuine debt, because reclassification costs the company its interest deduction and can turn the shareholder’s own money coming back into a taxable dividend.
The Journal Entry and Where It Sits
When the shareholder wires the funds, record a debit to Cash for the principal and a matching credit to Shareholder Loan Payable. That liability stays on the books until the loan is repaid.
Classification on the balance sheet follows the repayment schedule. If the entire principal is due within 12 months of the reporting date, the balance goes under current liabilities. If repayment extends past a year, the long-term portion sits under non-current liabilities. Multi-year loans get split: the portion coming due in the next 12 months is current, the rest is long-term. Update that split every reporting period as payments come due.
Booking Interest and the 2.5-Month Payment Rule
The company records interest expense on the outstanding balance every period, whether or not it has actually paid the shareholder. The entry is a debit to Interest Expense and a credit to Interest Payable. Skip it and you understate liabilities and overstate income.
Related-party lending adds a wrinkle that arms-length borrowing does not have. When the shareholder owns more than 50% of the company’s stock and reports income on a cash basis, the company can only deduct interest in the year it actually pays. If accrued interest is not paid within two and a half months after the company’s tax year ends, the deduction for that year is permanently lost.1eCFR. 26 CFR 1.267(a)-1 – Deductions Disallowed The 50% test uses constructive ownership, so shares held by family members and certain related entities count.2Office of the Law Revision Counsel. 26 U.S. Code 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
The practical rule: if you’re a majority shareholder, make sure the company cuts you a check for the accrued interest before that window closes. Paper accruals alone will not preserve the deduction.
Charging Enough Interest
Undercharging on interest creates a separate tax problem on top of any debt-classification concerns. Federal law treats the gap between what you charge and a statutory minimum rate as a taxable transfer between the company and the shareholder.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
That minimum is the Applicable Federal Rate, published monthly by the IRS. There are three tiers by term: short-term (up to three years), mid-term (more than three, up to nine), and long-term (over nine years).4Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings The AFR in effect when the loan is made is the one that applies.
If the stated rate falls below the AFR, the IRS treats the forgone interest as if the corporation paid it out to the shareholder as a distribution, and the shareholder then handed it back as interest. Both sides owe tax on amounts that never moved.
One narrow safe harbor: if the total outstanding loan balance between the corporation and the shareholder stays at $10,000 or below, the imputed interest rules do not apply.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates That threshold covers small short-term advances, not much else.
Keeping the Balance Sheet Entry Classified as Debt
The IRS can look at a shareholder advance sitting on your balance sheet as a liability and recharacterize it as equity. The Treasury has authority to prescribe factors for distinguishing debt from equity, and those factors track what courts have applied for decades.5Office of the Law Revision Counsel. 26 U.S. Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness No one factor decides it, but the overall picture has to look like a real loan.
- A written promissory note with a fixed rate and a fixed maturity date.
- An interest rate at or above the AFR that reflects what an unrelated lender would charge.
- A realistic ability to repay based on the company’s projected cash flow at the time the loan was made.
- A claim that is not automatically subordinated to every outside creditor.
- A reasonable debt-to-equity ratio. A company funded almost entirely by shareholder loans with minimal equity is thinly capitalized and draws scrutiny.
- Advances that are not perfectly proportional to stock ownership. When two 50/50 shareholders each lend the same amount on the same terms, the mirror pattern suggests equity.
- Actual enforcement of terms. A real creditor demands payment when a borrower defaults. Letting missed payments slide undercuts the debt story.
Proportionality is the factor that catches people out. Staggered amounts, different rates, or different timing across shareholders help break the pattern.
Documents to Have in the File
Every debt factor above ultimately turns on documentation. If it isn’t written down before the money moves, you’re asking the IRS to take your word for it.
Three documents carry most of the weight. A promissory note stating the principal, a fixed interest rate at or above the AFR, a payment schedule, and a definite maturity date, signed on or before the date of the cash transfer. Board minutes or a resolution formally authorizing the borrowing, recording the business purpose and the terms. And, if the loan is secured, a security agreement plus a UCC-1 financing statement filed with the appropriate secretary of state. Perfecting the security interest isn’t required to qualify the advance as debt, but it’s strong evidence that the shareholder acted like a real creditor.
Ongoing compliance matters as much as the paperwork at closing. Scheduled principal and interest payments should be made on time and recorded on the books. If the company can’t pay, the shareholder should respond the way any lender would: written notice, a documented forbearance, or other formal steps.
Tax Treatment When the Loan Holds Up
When the advance qualifies as genuine debt, the treatment is straightforward. The company deducts interest paid as an ordinary business expense. The shareholder reports the interest received as interest income. If the company pays more than $10 in interest during the year, it issues a Form 1099-INT to the shareholder.6Internal Revenue Service. About Form 1099-INT, Interest Income Repayment of principal is not a taxable event for either side; it’s just the return of the shareholder’s capital.
One cap to check: under Section 163(j), a business’s net interest deduction is generally limited to 30% of adjusted taxable income, with any disallowed amount carrying forward. Businesses that meet a gross receipts test, averaging $31 million or less over the prior three years as of 2025, are exempt.7Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Most closely held businesses receiving shareholder loans fall under the exemption, but run the numbers if the company also carries significant outside debt.
What Reclassification Costs
If the IRS recharacterizes the loan as a capital contribution, the company loses every interest deduction previously claimed on the reclassified amount. The shareholder’s stock basis goes up by the reclassified principal, which helps only when the stock is eventually sold.
The larger hit comes on repayment. Because the “loan” is now equity, repayment becomes a corporate distribution. To the extent the company has current or accumulated earnings and profits, that distribution is taxed as a dividend. The corporation gets no deduction for dividends. Any amount above earnings and profits reduces the shareholder’s stock basis, and anything past that is capital gain. The shareholder ends up taxed on money they originally lent to the company.
S-Corporation Loans Carry a Basis Wrinkle
Shareholder loans matter more in an S-corp because of how loss deductions work. An S-corp shareholder can only deduct passed-through losses up to the sum of stock basis and debt basis (basis in loans they personally made to the corporation).8Internal Revenue Service. S Corporation Stock and Debt Basis Losses beyond both pools are suspended and carried forward.
Losses reduce stock basis first, then debt basis. When the company returns to profit, income restores debt basis first, and only then rebuilds stock basis.9Office of the Law Revision Counsel. 26 U.S. Code 1367 – Adjustments to Basis of Stock of Shareholders, Etc. That ordering matters if the company repays the loan before debt basis is fully restored: the shareholder recognizes gain on the shortfall. A formally documented loan produces capital gain; an informal open-account advance produces ordinary income, taxed at higher rates.
If a shareholder loan to an S-corp fails the debt test, the advance is treated as an additional stock contribution. Stock basis goes up, but the separate debt basis pool is lost entirely.8Internal Revenue Service. S Corporation Stock and Debt Basis In a loss year, that lost pool can mean deductions the shareholder can’t use.
Reporting the Loan on the Tax Return
The balance sheet entry has to match what shows up on the return. On Form 1120-S, the loan balance goes on Schedule L (Balance Sheets per Books), Line 19, labeled “Loans from shareholders.” Each shareholder’s Schedule K-1 must also report the debt the S-corp owes directly to that shareholder at the beginning and end of the year.10Internal Revenue Service. Instructions for Form 1120-S On Form 1120, shareholder loans appear as liabilities on Schedule L.
The IRS cross-references Schedule L against individual K-1s and against loan documentation. Discrepancies between the balance sheet, the K-1, and the underlying note are among the first things auditors flag, so the numbers on the books and the numbers on the return need to line up.
If the Shareholder Forgives the Loan
Forgiveness gets treated differently depending on how it’s structured. When a shareholder cancels the debt as a contribution to the company’s capital, the corporation is treated as having satisfied the debt at an amount equal to the shareholder’s adjusted basis in the loan, which is usually the outstanding principal. If basis equals face value, no cancellation-of-debt income results for the corporation.11Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness The shareholder’s stock basis goes up by the forgiven amount.
A forgiveness that isn’t structured as a capital contribution, such as a simple write-off, can produce cancellation-of-debt income for the corporation equal to the face value of the loan. An insolvent corporation can exclude that income up to the amount of its insolvency; a solvent one owes tax on the full amount. For S-corps, those exclusions apply at the corporate level, not at the shareholder level.11Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness
The structure has to be decided before the forgiveness is executed, because the difference between a capital contribution and a simple cancellation can be a large tax bill the company wasn’t expecting.