What is a Shareholder Loan Agreement
A shareholder loan agreement is a type of loan contract between a corporation and one of its shareholders, as the name suggests, whereby the corporation borrows money from its shareholder. Shareholder loan agreements are most often used by closely held corporations where there is either one shareholder who is also the sole director, or where the agreements between the shareholders and other directors are structured so that a shareholder loan between one of the shareholders and the corporation may be made. Even at corporations where there is a corporation policy that prohibits loans to shareholders, a shareholder can typically enter into an agreement with the corporation to make a shareholder loan. The limits on shareholder loans contained in the corporate policy would not apply to the shareholder loan agreement. In most instances, in order to comply with the legislative requirements under provincial and federal statutes applicable to corporations, the loan must receive the approval of all of shareholders and directors, or the majority of them, depending on the shareholder loan agreement and the applicable corporate statutes.
Typically, the purpose for which shareholder loans are made is to provide capital for the business of the corporation, fund a shareholder’s purchase of shares in the corporation or to allow the corporation to repay a loan from an arm’s length party on more favourable terms, such as to consolidate loans at lower interest or to allow the company to avoid having to pay a penalty on a loan prepayment (which may be avoided if shareholder loans are used to refinance arms’ length debt) . In addition, any amount owed to the corporation by the shareholder, including a deposit made in a company account or any other debt, must be recorded as a loan between the parties. The shareholder loan agreement will contain the typical terms and conditions of a loan. It will indicate the amount of the loan, and the terms upon which the loan will be advanced to the corporation, including the date, any fee and other payments and the interest rate. Interest rates on shareholder loans vary and are generally based on the prime lending rate or the Bank of Canada’s rate for loans issued. Shareholder loans are usually referred to by accountants as director’s loans or accrued interest (when the loan is unsecured) and most commonly compel the repayment upon demand. This may allow the corporation to decide whether to repay the loan or not when it is made. In certain cases, however, repayment will be withheld until certain key events in the company’s history (such as a sale of the company, its issuance of shares or debt financing, or a number of other events). There is the possibility that the shareholder is owed money by the corporation. In that case, depending on the terms of the agreement between the parties, the shareholder may wish to offset the debt owed to him or her against the debt that is owing by him or her. A shareholder which owes the company may also choose to reduce the amount of the debt that is owed to it by converting the loan between it and the corporation into equity in the company.
Essential Components of a Shareholder Loan Agreement
Much like a personal loan between two people, a shareholder loan agreement contains all the terms and conditions under which a shareholder is lending money to the company in question. It’s a vital document that essentially "formalizes" the loan and creates a writeable record of the process and its terms. The following must be included in the written agreement:
Amount of Loan: Before providing a shareholder loan, clearly state how much money will be available through the loan. This amount is typically provided as both a word quantity (i.e., "Ten Thousand Dollars") and a number quantity ($10,000). Clearly defining the amount of the loan can also help the lender track how much has been repaid and how much is outstanding, since it clearly states the beginning and ending balance.
Amount of Interest: Many shareholder loans will charge interest. It’s important to define the rate of this interest when crafting your agreement. You’ll want it to come in at a preferable amount, but also must be careful to charge enough interest that the loan isn’t categorized as a gift or interest-free loan by the IRS. There are many methods for calculating interest (simple, compound, etc.), so be sure to write the agreement clearly so both parties understand how it will be calculated.
Repayment Schedule: Tailor your repayment schedule in a way that helps you best manage your cash flow. You could be repaid all at once at an agreed-upon time in the future, or you could give the borrower a grace period, follow that with monthly payments and then the final balance all at once. Set a schedule that is flexible enough to accommodate both your needs, but specific enough to ensure you can operate within its confines.
Rights of the lender and borrower: Any loan should specify what happens if the borrower fails to make payments, is unable to pay back the loan including interest, or goes bankrupt. There are no clear rules on which specific actions must be taken in such situations, but both parties should be clear on what to expect from one another.
It’s a good idea to read an example shareholder loan agreement before drafting your own, as this can give you an example of what a completed document looks like. Check our post in which we share an example shareholder loan agreement, which may help fill out the blanks as you craft your own contract.
Legal Considerations and Tax Implications
A shareholder loan agreement is a binding contract and as such, parties must be aware of the legal responsibilities they incur upon execution. Misunderstanding these responsibilities can lead to disputes between shareholders and the company.
A legal accounting perspective
From a legal perspective, a lender intends to recover its money and a borrower usually intends to obtain the loan as cheaply as possible. The funds received by the borrower are a liability, while the funds paid by the borrower are income. Failing to recognize and differentiate between shareholder loans and share capital can result in conflicts with the tax authorities. Legal accounting taxes the funds received by the borrower as borrowed capital, not as income. Income tax is paid by the borrower on the interest paid, and the lender is subject to dividend tax on the same amount. This creates a situation where the company has paid the tax twice and the shareholder pays more tax than would have been the case had the funds been received by way of share capital. However, in practice, the company has received the funds and must ensure that all taxes are paid.
Unless all parties are averse to these additional tax liabilities, or unless otherwise directed by the shareholders, shareholder loan agreements should be drafted to comply with prevailing tax legislation. Any obligations related to compliance or otherwise will fall to the directors whose decision ultimately must be disclosed to shareholders.
A company is required by law to maintain proper records of its loans as part of financial record-keeping. In the event of an insolvency, the company’s shareholders will be required to produce shareholder loans to the liquidator. A liquidator will seek to have the company repaid following its winding-up if, for instance, the company borrowed from a third party to repay shareholders.
Tax implications
Any payment made to a shareholder by the company will be taxed as income in the hands of the shareholder and the same amount will be taxed as dividend tax in the hands of the company. All transfers including capital, loans and dividends are viewed as both the transferor and transferee being the debtor and the creditor.
Tax implications and consequences for the company
A company is required to prepare and maintain record-keeping documentation concerning its loan accounts. A company will be required to report its loans on its annual return and submit a report on its activities annually to the Director of Companies. Each year, a company must report to the Director of Companies any money lent and/or advanced to directors. Failure to produce all corporate documentation to the Director of Companies will mean the company will not be able to satisfy a liquidator by proving that a loan has taken place. These obligations are primarily the responsibility of the directors. Nonetheless, the company’s shareholders will be personally liable for these amounts.
Tax implications and consequences for the shareholder
The shareholder is required to disclose a loan account in the company’s annual returns and personal tax returns annually. A shareholder will be unable to recover his or her shares if he or she has not provided a loan to the company.
How to Draft a Tailored Shareholder Loan Agreement
In some cases, a more tailored approach is advisable to ensure that the agreement meets the specific needs of the parties and accounts for any special factors involved in the transaction. Here are the steps involved in drafting a custom shareholder loan agreement: Reviewing the Transaction: Initially, it is important to step back and assess the full scope of the transaction and what all parties desire from it. Assembling Key Terms and Conditions: After reviewing the shareholders and the loan, gather all of the key terms and conditions and begin to assemble a template for the shareholder loan agreement. Be sure to include the organization’s information, the date of the transaction, a description of the loan, the parties involved, the terms of repayment, prepayment, default and any other relevant clauses. Drafting and Proofreading: After you have compiled all of the terms and conditions, draft the shareholder loan agreement and ensure that you proofread it for any typos or errors. Finalize the Agreement: If all parties agree to the terms and conditions of the shareholder loan agreement, then the document can be finalized and signed. It is important to ensure that all parties understand the terms contained within the agreement and to ensure that the agreement is signed in such a way that it is legally binding. Whether a customized shareholder loan agreement is necessary or not, it is always a good idea to consult an attorney with experience in drafting such agreements. An attorney can ensure that the shareholder loan agreement is permissible under the law and meets all of the requirements of the unique relationship between the parties involved.
Sample of a Shareholder Loan Agreement Template
This loan agreement ("Agreement") is made as of the ___ day of ____ 20__, by and between ____________________ (the "Lender"), a ____________________ and ____________________ (the "Borrower"), a _________________. In consideration of the mutual agreements of the parties herein contained, it is agreed as follows:
- LOAN. The Lender hereby loans to the Borrowers, and jointly and severally, the aggregate sum of $________ (after 100% of the Loan becomes due as specified below), on the terms and conditions set forth in this agreement (the "Loan").
- PAYMENTS. The principal, interest, and any other charges owing to the Lender under this Agreement will be paid in full: (a) upon a Change of Control of the Borrowers, and/or (b) upon such date or events as shall be declared by the Lender to be the date for termination as provided for herein or in any other agreement(s) to which the parties may subsequently enter into regarding the Loan (the "Due Date"). The Borrowers’ payment(s) shall be made to _________________ (the "Agent"), to be held, invested, and released by Agent to Lender at the times and upon the terms set forth in this Agreement.
- AGENT’S AUTHORITY. The Lender appoints the Agent as their true and lawful attorney-in-fact with full power and authority to act for and on behalf of the Lender in all matters relating to their interests hereunder, including, but not limited to, the power and authority: (a) to receive and receipt for all payments and collection of all accounts receivable; (b) to compromise, settle and extend the terms of any debt owed to Lender by the Borrowers and/or to institute, prosecute or defend any action or proceeding in connection with any Contract or with respect to any other matter arising under this Agreement or any other agreement(s) to which the parties may subsequently enter into regarding the Loan; (c) to execute , acknowledge and deliver, on behalf of the Borrowers, all instruments, conveyances and other documents which in the opinion of Agent are necessary or appropriate to effectively carry out the decisions of the Lender hereunder; (d) to substitute from time to time agents, having all of the rights and powers granted the Agent, as it shall deem appropriate in the best interests of the Lender; and (e) as shall be permitted under this and any other Agreement to amend this Agent’s authority.
- PLEDGE OF VOTING STOCK AND OTHER SECURITY INTERESTS. The shareholders of the Borrowers’ shall pledge their stock as security for the Loans. Such pledge shall also include the right to receive all future dividends, payments for any equipment or other distributions legally made to the Borrowers. The voting rights associated with the pledged stock shall not pass to the Lender or the Agent, but shall remain with the Borrowers’ respective management. The Lender, and/or the Agent shall also have the right to enforce its rights to the pledges and receive all future payments until all of the Loans are satisfied in full.
- DISPUTES. This Agreement shall be governed by and construed in accordance with the laws of the State of California with respect to transactions performed in the State of California and without regard to its conflict of laws section. The parties to this Agreement agree that any dispute between them shall be submitted to the American Arbitration Association and that the provisions of the American Arbitration Association’s Commercial Arbitration Rules and Mediation Procedures shall apply to arbitration proceedings. I have read the foregoing and hereby agree to all of the terms and conditions set forth therein and execute this agreement as of the date first above written.
Common Mistakes to Avoid
Shareholders often make heavy weather of loan agreements, especially when the amounts involved are substantial. We have received a number of queries on what shareholders sometimes get wrong in drafting loan agreements and this prompted us to present some of the most common pitfalls, the legal principles behind them and why the principles matter to shareholders. The key to avoiding future disputes is having a loan agreement which sets out the expectations of both parties clearly and prevents future ambiguity and dispute.
It is common for shareholders of a company to borrow money from it (or vice versa) for all manner of purposes, including the purchase of shares in the company (to obtain additional shares), to settle tax liabilities and to fund a new business venture. The terms of the loan may be recorded within a single agreement or across multiple documents and correspondence.
COMMON PITFALLS
Mistake 1: the parties to the loan are not clearly identified
We have seen loans which do not properly identify the lender and borrower. This is especially the case where there are several shareholder directors and the company itself is also a director or a party. Care should be taken to identify exactly who is lending to and borrowing from the other party to the loan. An incorrect identification can invalidate the loan agreement between the parties.
To avoid this, carefully review the identity of the lender and borrower to ensure there can be no uncertainty. The following should be clearly set out:
Mistake 2: lack of clarity over why the loan is being made
The loan should clearly set out why it is being made and state that the entire purpose is the loan to the shareholder personally, that there is no loan to the company and that the loan will not be treated as any kind of investment in the company. This is especially the case where the loan agreement has been entered into following the sale of shares where the original buyer has failed to complete the transaction and it has been agreed that a loan will be advanced to fund the purchase.
The separate nature of the loan to the shareholder and the company should also be expressly stated in the agreement to avoid bringing the loan into question.
Mistake 3: the terms of the loan are not clearly set out
It is important that the repayment schedule, interest and other terms are clearly set out in the loan agreement so that the parties know what is expected of each other. Failure to set out the terms of the loan clearly may not invalidate the agreement but could give rise to dispute if either party believes that the other is not complying with the terms of the loan. It might be the case that one party states that the loan is repayable on demand when the other states that it is repayable in instalments. It is therefore important to set out clear provisions for payback and what happens if the borrower does not pay back the loan. Without these terms, the parties may not be clear on the terms of the loan and this could lead to claims by one party that the other is not complying with the terms. This could result in court proceedings in the case of a dispute between the parties.
Mistake 4: parties fail to expressly take into account company policies and procedures which may affect the loan agreement
Company policies and procedures should be followed when entering into loan agreements and they should clearly confer authority on a party if it is not taking place in the ordinary course of business. For example, a company may have an agreement that all loans must be reviewed and signed off by a director, or those above a certain value must be approved by the shareholders.
For these reasons, it is always prudent to check the articles and shareholder agreement to ensure that the proposed loan does not contravene them and to ensure approval of any shareholder dividends, such as a directors’ resolution or approval by the shareholders in general meetings.
Mistake 5: lack of appropriate legal advice
When reviewing or entering into a loan agreement, it is important to obtain appropriate legal advice from a specialist solicitor. This is so that the parties enter into an agreement which reflects the intention of the parties and is compliant with the law in order to ensure that the agreement can be enforced and that each party knows their rights and obligations under the agreement.
Best Practices: Shareholder Loan Agreements
In conclusion, shareholder loan agreements are an essential tool for companies to obtain necessary funding while allowing shareholders to earn interest and secure their investments. However, it is critical to ensure that such agreements are carefully drafted and maintained. Failing to adhere to best practices can result in serious consequences for both the company and the lender, including negative implications for financial statements and taxation.
We have provided a variety of examples and best practices for creating a shareholder loan agreement, from simple unsecured loans to securing the loan with specific assets. The most important aspect is to ensure that the loan agreement is clear and comprehensive. This includes detailing repayment terms, interest calculation, restrictions on the use of funds , and any security interests.
Having a well-drafted shareholder loan agreement is not only advantageous for the company; it also protects the investor’s interests. A properly secured loan agreement may provide a remedy for default on the interest or the principal through the secured asset. This is another reason why getting professional advice for both the company and the lender is so critical.
In addition to getting professional advice, it is important for the company and the lender to keep open communication lines for clarification of any issues that may arise throughout the term of the loan. Shareholder loans should be dealt with in the same manner as you would with a third-party lender.
Being informed and consulting professionals when establishing and maintaining a shareholder loan agreement will ensure that the process is smooth and benefits all parties involved.