Loans to directors are legal in some settings and flatly prohibited in others. If the company is publicly traded, federal law bans almost all personal loans to directors and executive officers. If the company is privately held, a loan is permitted but only if the board approves it properly, the paperwork looks like an arms-length transaction, and the interest rate meets IRS minimums. Nonprofits face their own, stricter regime, and getting any of this wrong can mean excise taxes, reclassified income, or, at public companies, criminal exposure.
Public Companies: A Near-Total Ban
Section 13(k) of the Securities Exchange Act, added by Sarbanes-Oxley in 2002, makes it illegal for any publicly traded company to extend personal credit to its directors or executive officers. The prohibition covers direct loans, loans routed through subsidiaries, guarantees of a director’s third-party debt, and pledges of corporate assets as collateral for a director’s personal borrowing.1Office of the Law Revision Counsel. 15 USC 78m – Periodical and Other Reports
The ban applies to every “issuer” under the Act. Foreign companies listed on the NYSE or NASDAQ get no exemption, so a foreign private issuer is treated the same as a domestic corporation.
The statute carves out a few exceptions, all aimed at companies whose business is consumer lending. A public bank, credit union, or other consumer lender may lend to its own directors if three things are true at once: the loan is made in the ordinary course of the company’s consumer lending business, the same type of loan is offered to the general public, and the terms are no more favorable than what outside customers receive.1Office of the Law Revision Counsel. 15 USC 78m – Periodical and Other Reports A parallel exception covers insured depository institutions when the loan is subject to federal banking law’s insider lending rules. Broker-dealers may extend credit to their own employees for buying or carrying securities under Federal Reserve rules, but not to buy the issuer’s own stock.
Ordinary business advances — a corporate card for travel, pre-approved expense reimbursements — sit outside the ban when they are small, tied to genuine business purposes, and repaid promptly. Unreimbursed personal charges that linger on the books start to look like personal loans, and the SEC has pursued enforcement over advances outstanding for as few as five days when the underlying use was personal.
Penalties
A willful violation of the Exchange Act, including Section 13(k), can bring criminal fines of up to $5 million for individuals and up to $25 million for the company, plus up to 20 years in prison.2GovInfo. 15 USC 78ff – Penalties The SEC can separately seek injunctions, disgorgement, and officer-and-director bars, and can name individuals in its proceedings.
Private Companies: Board Approval Is the Whole Ballgame
Private companies are not covered by Section 13(k), but state corporate law lets a company lend to a director only when the board determines the loan can reasonably be expected to benefit the corporation. A loan that does nothing but enrich the director will not survive challenge.
Because the borrowing director has an obvious conflict, approval should come from disinterested directors — board members with no personal stake in the transaction. The borrowing director leaves the room during the discussion and abstains from the vote. Some companies also seek shareholder approval, excluding the interested director’s shares from the count.
The board’s reasoning has to go into the minutes: why the loan benefits the company, what the terms are, and why those terms are comparable to what an unrelated borrower would get. That paper trail is the company’s primary defense if a shareholder later sues over self-dealing. Without it, the director can be personally liable for any losses the company suffers, and a court may void the loan.
Making the Loan Look Like a Loan to the IRS
Corporate approval alone does not protect the tax treatment. If the IRS concludes the transaction is not a real loan, it reclassifies the entire disbursement as taxable income to the director. Avoiding that outcome takes documentation that mirrors a transaction between strangers.
Start with a written promissory note signed by both the director and a corporate representative. It has to state a principal amount, a fixed maturity date or repayment schedule, and an interest rate. No written obligation, no loan, as far as the IRS is concerned.
The interest rate must meet or exceed the Applicable Federal Rate, which the IRS publishes monthly. The AFR is the floor for related-party loans, and it comes in three tiers: short-term (three years or less), mid-term (over three to nine years), and long-term (over nine years).3Internal Revenue Service. Applicable Federal Rates AFRs Rulings
Repayment matters as much as the paperwork. A note that sits in a drawer while no payments are made or collected tells the IRS the parties never meant this to function as debt. Repeatedly extending the maturity or quietly waiving payments sends the same signal.
Charging Less Than the AFR
When the interest rate falls below the AFR, IRC Section 7872 creates phantom tax consequences on both sides. The IRS treats the missing interest as if the company paid the director cash and the director paid it back as interest. Neither transfer happens in reality, but both sides owe tax as if they had.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates Charging at least the AFR from day one avoids the whole calculation.
When the IRS Says It Isn’t a Loan
If the IRS knocks down the loan characterization, it has to reclassify the funds as something else. The two usual outcomes are compensation and constructive dividend, and the tax bills look quite different.
If the director is also an employee, the disbursement often becomes additional compensation. The company can deduct it, but both sides owe payroll taxes, including the employer’s share of Social Security and Medicare. The director owes income tax on the full amount, and the company owes back employment taxes plus penalties for failing to withhold.
If the director is primarily a shareholder, the more likely label is constructive dividend. Dividends are not deductible, so the company gets no offsetting tax benefit. The director still owes income tax on the amount, and if the payment doesn’t qualify for preferential dividend rates, the ordinary-income treatment combined with the lost corporate deduction is where most of the real financial damage happens.
Forgiving a Director Loan
If the company later forgives all or part of a director’s balance, the canceled amount is generally taxable income to the director in the year of the forgiveness.5Internal Revenue Service. Topic No 431 Canceled Debt – Is It Taxable or Not The company reports the cancellation, and when the forgiven amount is more than $600, it may need to issue a Form 1099-C.6Internal Revenue Service. About Form 1099-C Cancellation of Debt The director must report the correct amount regardless of what the company sends.
Forgiveness also reopens the compensation-versus-dividend question. Forgiving debt as a reward for services looks like compensation and drags in payroll taxes; forgiving debt owed by a shareholder looks like a distribution. Planned forgiveness is really just deferred compensation with more paperwork, and it is usually cleaner to structure it that way from the start.
Nonprofit Directors: Tighter Rules
Directors of tax-exempt organizations face restrictions that in many cases go beyond what private for-profit companies deal with.
Private Foundations
For a private foundation, any loan to a director or other disqualified person is an act of self-dealing under IRC Section 4941, no matter how fair the terms or how careful the approval. The IRS imposes a 10 percent excise tax on the self-dealer for each year the loan is outstanding, plus 5 percent on any foundation manager who knowingly participated in approving it. If the transaction is not corrected within the taxable period, the penalties jump to 200 percent for the self-dealer and 50 percent for a manager who refused to correct. Correction here means unwinding the loan through full repayment plus interest.7Office of the Law Revision Counsel. 26 USC 4941 – Taxes on Self-Dealing
Public Charities and Other 501(c) Organizations
Public charities and other groups described in Section 501(c)(3), (c)(4), or (c)(29) fall under the excess benefit transaction rules of Section 4958 rather than the self-dealing ban. A below-market loan to a director is an excess benefit transaction to the extent the benefit to the director exceeds the consideration the organization gets back. The initial excise tax is 25 percent of the excess benefit, paid by the director. An organization manager who knowingly approved the transaction owes 10 percent, capped at $20,000 per transaction. Uncorrected excess benefits draw an additional 200 percent tax on the director. Section 4958 does not create an absolute ban, so a loan at genuine fair-market terms is possible, but the margin for error is thin.8Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions
Retirement Plan Money Is Off-Limits
A company’s retirement plan cannot lend to a director in their capacity as a company insider. Under ERISA, lending between a plan and a “party in interest” is prohibited, and directors, officers, and employers are all parties in interest.9Office of the Law Revision Counsel. 29 USC 1106 – Prohibited Transactions
There is a narrow exemption for participant loans, meaning a loan from the plan to a director who is also a plan participant borrowing against their own account balance. To qualify, the loan has to be available to all participants on a reasonably equivalent basis, not be disproportionately available to highly compensated employees, follow the loan provisions in the plan document, charge a reasonable interest rate, and be adequately secured.10GovInfo. 29 USC 1108 – Exemptions From Prohibited Transactions A special loan created for the director, funded from general plan assets, or offered on preferential terms is a prohibited transaction.
Disclosure and Reporting
Every loan to a director is a related-party transaction. GAAP’s ASC Topic 850 requires financial statements to disclose material related-party transactions, including the nature of the relationship, a description of the transaction, and the dollar amounts. That applies to public and private companies alike.
Public companies also have to comply with SEC Regulation S-K, Item 404. It requires disclosure of any related-party transaction where the amount involved exceeds $120,000, and for loans specifically the company must report the largest principal balance outstanding during the reporting period, the current balance, the principal and interest paid during the period, and the interest rate. Smaller reporting companies use a different threshold: the lesser of $120,000 or one percent of average total assets at year-end for the last two completed fiscal years.11eCFR. 17 CFR 229.404 – Transactions With Related Persons, Promoters and Certain Control Persons
Private companies have no SEC filing, but the loan terms, board approval, and repayment history should still be disclosed to shareholders to preserve the board’s duty of candor. Concealing a director loan from the shareholders is a fast path to a derivative lawsuit challenging the transaction’s fairness.