Those who have closely-held businesses will need to advance money to their companies at times, whether to bridge a temporary downturn or to supply additional cash flow for a major expense, an expansion or something else. Are these advances supposed to be classified as bona fide debt, additional paid-in capital or something in between? Your answer, under U.S. Generally Accepted Accounting Principles (GAAP), will be determined by the facts and conditions of the transaction.
Debt vs. equity
Correctly categorizing the shareholder advances is crucial, particularly when a business possesses unsecured bank loans or more than one shareholder. Tax purposes also require accuracy in classification, because advances that fall under a “debt” category generally demand imputed interest charges. Of course, the tax rules may not always coincide with GAAP.
In addition to those complications, shareholders occasionally absolve the company of loans or convert them to equity. Difficulties arise in accounting for these kinds of dealings when the fair value of the equity is distinct from the carrying value of the debt.
As you choose how you will categorize shareholder advances, remember to take into account the economic substance of the transaction over its form. When it’s time to classify these transactions, please look closely at the following components:
Intent to repay. Open-ended agreements between related parties regarding repayment presuppose that an advance is a form of equity. For instance, an advance may be categorized as a capital contribution if it was given to protect the company from impending failure, and there have been no efforts made to pay it back.
Loan terms. For an advance to be considered bona fide debt, both parties must have signed a written promissory note that carries reasonable interest, has a fixed maturity date and a record of intermittent loan repayments, and contains some collateral. On the other hand, if the advance is subordinate to bank debt or other creditors, it will probably be considered as equity instead.
Ability to repay. This encompasses the company’s historical and future debt service capacity, in addition to its competence in acquiring other funding methods and its credit standing. The more secure these pieces, the more suitable it is to categorize the shareholder advance as debt.
Third-party reporting. Regularly handling an advance as debt (or equity) on tax returns can give added insight into its proper classification.
Disclosures are fundamental when if comes to shareholder advances. You are obligated to recount any related-party transactions under GAAP, together with the magnitude and specific line items in the financial statements that have been impacted. If you have many related-party transactions, you might need to use a tabular format, so the footnotes from the financial statements are easier to navigate.
Shareholder advances bring with them financial reporting complications that can’t be resolved with a one-size-fits-all answer. You may need the individualized attention we can offer as we work together to address the unique challenges you face. Call us at 818-334-8623 or click here for help to figure out the best way to disclose your transactions in your financial statement footnotes.