How to Convert Loans to Directors Into Dividends

A member of the board of directors must also be a shareholder to have any dividend rights at all.

In corporations, it is very important to understand the distinction between different types of financial transactions between directors, shareholders and the corporation. For example, there are important tax consequences involved in distinguishing between loans and dividends. Loans are not taxed because they must be repaid; salaries and bonuses are taxed as regular income; and dividends are taxed as ordinary income.

Instructions

1. Find out if the company is eligible to issue a dividend. Most jurisdictions require that a company pay a dividend only out of profits, meaning that a currently unprofitable company may not be able to pay a dividend at all.

2. Research the dividend policy of your company. The dividend policies that are applicable to the various classes of stock in the company are contained in the company's articles of incorporation. It is important to keep the dividend policy in mind when attempting to convert a loan into a dividend because the articles may require that certain classes of shareholders be paid a dividend before others.

3. Determine the dividend policy applicable to the director's stock. If the director is not a shareholder, he will be ineligible to receive a dividend, because, by definition, dividends are only available to shareholders. If the stock class of the director has dividend rights that are subordinated to those of other classes of stock, it may be necessary to acquire a waiver of dividend rights from holders of superior classes of stock.

4. Acquire a waiver of dividend rights from holders of superior stock if the director's stock is subordinated to other classes of stock. This may be very difficult depending on the shareholders, as most shareholders are reluctant to waive their right to a dividend in any situation.

5. Ensure that the entire transaction is clearly established as converting the director's loan into a dividend. Have the relevant parties sign an agreement that states that the waiver of any dividend rights and the payment of the director's dividend is for the purpose of having the company's loan obligation eliminated in favor of paying the director a dividend, despite the existence of superior dividend rights, if any.

References

• Sprouce Shrader Smith, PC: IRS Successfully Recharacterizes S Corporation Dividends as Salary
• New York University: Dividend Policy
• USLegal: Dividend Law and Legal Definition