Because of the close relationship and relatively small numbers of shareholders in S corporations, those shareholders often take a greater role in the management of the company. In addition to taking management positions, shareholders of S corporations sometimes loan money to the corporation. When a shareholder does this, he also becomes a creditor and has a right to a repayment of that loan upon dissolution of the corporation, if it has not been repaid previously.
An S corporation is a special type of business association that combines the limited liability of a C corporation with the preferential tax treatment of a partnership. Generally, S corporations tend to be smaller than C corporations and have a much greater level of shareholder participation in the company. For this reason, there are special rules regarding many aspects of the relationship between shareholders and the corporation.
Because of the closely held nature of many S corporations, many shareholders will make loans directly to the company. One of the most important considerations involving shareholder loans are whether they are considered loans or are treated as creating a new class of stock. This is important not only for tax purposes but also for the right of the shareholder to reclaim that loan upon dissolution.
When a company ends its course of business, it must go through a process of dissolution. Dissolution involves not only winding up the affairs of the company, but also liquidating company assets and distributing those assets to the relevant stakeholders. These stakeholders include both creditors and shareholders. In the event of a shareholder loan to a corporation, the shareholder becomes a creditor as well.
Order of Corporate Dissolutions
In general, creditors to a corporation are paid before shareholders and in accordance with the extent to which their loans are subordinated to other debt. If a shareholder makes a loan to the corporation, the shareholder has a right to have that loan repaid before assets are distributed to the shareholders in general. For example, if there are 10 shareholders in an S corporation that owes $100,000 to a bank, $50,000 in subordinated debt to Shareholder A and has a total of $250,000 in assets, the bank will be repaid first, followed by the $50,000 to the shareholder-creditor. The remaining $100,000 will be distributed to the shareholders in proportion to their level of ownership, including Shareholder A.