Importance of Documenting Loans

One issue that comes up more than it should is whether loans are properly documented.  Oftentimes a business lends money to its owners, or borrows money from its owners, without any note or even a memo documenting the loan!  This is not good.  When the auditors show up, oftentimes a transaction that nobody thought was taxable suddenly can be viewed as a dividend, or as additional payroll. 

It is very important when lending money from a company, or to a company (or really, whenever lending money), to document the term of the loan, the interest rate, a payment schedule, remedies for non-payment, etc.  While a carefully drafted loan agreement is ideal, even a short note that A lent B $X amount of money for Y years at Z interest rate is better than nothing. 

Another thing to consider is state lending rules, sometimes a loan that nobody thinks is a problem runs afoul of some state lending rule, and may even require that the lender register with the state before they can issue the loan.

All in all, it pays to put a little extra care into documenting loans, especially for closely held businesses.  This means proper loan documentation, and it also means consistent treatment, both in internal company financials, and on tax returns.  Nothing is worse than saying to an auditor "well, it really is a loan, but we didn't document it" or "we didn't book it."  And nothing makes an audit go easier than being able to give the auditor proper loan documentation, and internal books and records that match up perfectly with what is on the tax return.

A final note?  Make sure to make regular payments on the loan if you can.  Often the best proof that a loan is indeed a loan is that it has been repaid.  And sometimes the IRS will point to the lack of any repayments as proof that a loan is actually a dividend, or extra (and unreported salary).  It pays to be careful. 

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